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Keywords:

  • Capital controls;
  • financial crisis;
  • financial liberalization;
  • D52;
  • E44;
  • F32;
  • F41

Abstract

We study the transitional dynamics of financial integration in emerging economies using a two-sector model with a collateral constraint on external debt and trading costs incurred by foreign investors. The probability of a financial crisis displays overshooting; it rises sharply initially and then falls sharply, but remains non-zero in the long run. While equity holdings fall permanently, bond holdings initially fall, but rise after the probability of a crisis peaks. Conversely, asset returns and asset prices first rise and then fall. These results are in line with the post-globalization dynamics observed in emerging markets, and the higher frequency of crises that they display.