How Has Financial Liberalization A ected Emerging Markets' External Capital Structure? An Explanation of the Link between Financial Openness, Sudden Stops and External Balances

This paper argues that occasionally binding borrowing limits and non-trivial equity trading costs signi cantly increase the probability of a Sudden Stop post nancial liberalization, which in turn, signi cantly alters the long run external capital structure of an emerging market economy. Upon opening the capital account, agents in the emerging market have an incentive to accumulate debt and sell domestic equity in order to share risk with the rest of the world. Due to a lower cost of capital, equity prices spike allowing agents to accumulate a relatively large amount of debt without being constrained in the near term. As domestic agents accumulate debt and sell equity to re-balance their portfolio, however, adjustment costs force equity prices to subsequently fall. With a lower value of equity, agents within the emerging market face a greater risk of hitting their "margin requirement", triggering a debt de ation crisis. In the long run, the probability of a sudden stop is small as agents accumulate pre-cautionary savings to avoid the sudden stop. However, the adjustment of the external capital structure is permanent. Calibrating the model to Mexico, we solve numerically for the transitional dynamics of a small closed economy as it opens and match both qualitatively and quantitatively the simulated dynamics to the data. JEL Codes: