Financial opennes, instability and adjustment in emerging market economies

In this paper I present a theoretical macrodynamical model with the aim of analyzing the vulnerability to systemic instability induced by financial integration for a small emerging market economy. I take the view stressed in Blanchard-Das-Faruqee (2010), and look at the role of the financial channel in the international transmission of the crisis from advanced economies. I explore analytically the macrodynamical implications for economic stability when integration into global financial markets determines an endogenous acceleration of debt-creating capital inflows that boosts growth and the prospect of future profits, thus leading to the building up of large imbalances in the private sector, and exposure to capital reversal. This paper provides a contribution to existing theoretical work by modeling the endogenous characterization of financial instability, the risk premium and, hence, the overall macroeconomic outcome in a dynamical perspective. The view taken here allows looking at the beyond-impact effects of the crisis. Moreover, it allows addressing the issue of the greater adjustment challenge, with respect to expected, in dealing with the contraction of international liquidity, when balance-sheet effects dominate the expansionary effects of devaluations. Hence, it is useful in understanding under what conditions stability may or may not be a likely outcome, despite the presence of flexible exchange rates, and thus motivate the sharp differences registered across countries. The analytical framework developed appears also useful for the discussion of issues regarding the effects of stabilization policies aimed at reducing the severity of the crisis.