Short-Run Pain, Long-Run Gain: Financial Liberalization and Stock Market Cycles

Short-Run Pain, Long-Run Gain:
                 Financial Liberalization and Stock Market Cycles

                                           Abstract

       Neoclassical theory indicates that financial liberalization reduces the cost of
       capital and leads to a permanent increase in equity prices. In contrast, the crisis
       literature links financial liberalization to large booms in borrowing and asset
       prices and ultimately financial collapses. This paper re-examines the impact of
       financial liberalization on stock market cycles and studies the dynamics between
       liberalization and institutional reforms. We also construct a new chronology of
       financial liberalization. We find that liberalization in emerging markets triggers
       more pronounced boom-bust cycles in the short run but more stable markets in the
       long run, partly because liberalization stimulates institutional reforms.

JEL classification codes: F30, F36, G12, G15

Keywords: financial integration, globalization, stock market prices, booms, busts, financial
cycles.

The crises of the past decades have ignited, once again, the debate on the effects of

financial liberalization. Neoclassical models argue that the cost of capital declines following

financial liberalization, triggering an increase in the value of firms. According to this view, the

deregulation of financial markets improves the allocative efficiency of domestic investment,

increasing productivity and growth. In this scenario, financial liberalization should be followed

by a significant boom in financial markets, but not by a large crash. This view is supported by a

number of recent papers in the finance literature. For example, Bekaert, Harvey, and Lundblad

(2005a, 2005b) find that liberalization leads to a persistent surge in annual economic growth as

well as to a decline in output volatility. Similarly, Chari and Henry (2004) and Henry (2000a,

2000b) find that liberalization triggers an increase in the investment rate and a substantial

revaluation of equity prices in a large number of emerging markets.

       While neoclassical theory emphasizes that financial markets are efficient, a different view

argues that financial markets suffer from distortions that generate anomalies in how markets

allocate resources. In this context, investors may overreact to shocks, becoming optimistic and

pouring capital beyond what is guaranteed by good fundamentals or withdrawing massively from

countries when problems arise. These distortions can manifest when financial markets are

liberalized and there is private or imperfect information, as emphasized in a number of

theoretical papers, like Bachetta and van Wincoop (2000), Calvo and Mendoza (2000), and

McKinnon and Pill (1997). Also, capital market imperfections are thought to be more pervasive

under the presence of inadequate government institutions as well as weak supervision and

regulation of the financial system.     In his presidential address to the American Finance

Association, Stulz (2005) concludes that when property rights are not guaranteed and

expropriation risks are significant, agency problems arise and ownership concentration increases.

                                                1

This limits economic growth and financial development, with financial deregulation leading to

capital flight and crises. Supporting these views, several papers find empirical links between

financial deregulation, boom-bust cycles, and banking and balance-of-payments crises. See, for

example, Corsetti, Pesenti, and Roubini (1999), Demirguc-Kunt and Detragiache (1999),

Kaminsky and Reinhart (1999), and Tornell and Westermann (2005).

        The observations that financial liberalization, despite its potential benefits, is followed by

crises and that weak institutions distort the functioning of the financial system has generated a

growing interest on the sequencing of financial liberalization and institutional reforms. One

view argues that, protected from outside competition, badly regulated and supervised banks do

not have the pressure to run efficiently. Liberalization in this scenario unveils a new problem as

protected domestic banks suddenly get access to new sources of funding. Moreover, as Hellman,

Murdok, and Stiglitz (2000) argue, the competition induced by financial liberalization lowers

bank profits, erodes banks’ franchise values, and diminishes their incentives for making good

loans, accentuating moral hazard problems.                Liberalizations, thus, might trigger excessive

financial booms and crashes, particularly in financially repressed countries with banks running

poor balance sheets. In these cases, sequencing is advised. For example, Radelet and Sachs

(1998) and Stiglitz (2000) argue that improvements in property rights as well as government

accountability and transparency should precede the deregulation of the financial industry to

avoid subsequent financial crises. More generally, a standard recommendation is to first upgrade

the regulation and supervision of financial markets, improve the health of the financial system,

and create a legal framework that enables the writing of private financial contracts; then

deregulate the industry and open up the capital account.1 Since there is general agreement that in

1
 See, for example, Johnston and Sundararajan (1999) and McKinnon (1993), as well as the advice by the then IMF
Managing Director Michel Camdessus (Financial Times 1998).

                                                      2

industrial countries property rights are better enforced and government institutions are better run,

there is typically no opposition to financial deregulation in those economies. But this type of

sequencing is often recommended to developing countries, especially to the ones that are not yet

fully open.

          A different view challenges the idea that reform should precede liberalization. According

to this alternative perspective, it is not clear whether governments face incentives to promote

reforms in countries with repressed financial sectors. Well-established interest groups will

oppose those reforms that would eventually undermine their incumbent advantage. Therefore,

financial liberalization should precede reforms, as it creates competition that leads to

improvements in property rights, transparency, and the overall contractual environment. This

view is expressed in recent work.        For example, Rajan and Zingales (2003a,b) study the

experience of twenty-four countries over a century, and find that trade openness is positively

related to financial development as it fuels the political will to undertake actions that guarantee

investor protection and change the legal system to help enforce contracts. Stulz (1999) and

Mishkin (2003) also claim that financial liberalization and globalization help to discipline

policymakers, who might be tempted to exploit an otherwise captive domestic capital market.

Moreover, they suggest that the integration of emerging economies with international financial

markets by itself may help to fortify the domestic financial sector, as foreign investors have

overall better skills and information and can thus monitor management in ways local investors

cannot.     Furthermore, Stulz (2005) argues that by opening borders, financial globalization

provides the means and incentives for corporate insiders to better protect minority investor

rights.

                                                  3

In this paper we analyze the different effects of financial liberalization by studying its

short- and long-run effects and its relation with institutional reforms. This analysis sheds new

light on the arguments discussed above. Namely, the intrinsic dynamics between financial

liberalization and government and corporate reform may be the key to explain the distinct

findings in previous empirical work on the effects of financial deregulation. Liberalization may

trigger excessive borrowing and ultimately financial collapse in the short run, as badly run and

protected financial institutions gamble for resurrection in the newly open financial system. But

deregulation sows the seeds of the destruction of the old protected system, with capital markets

becoming more stable and promoting productivity gains in the long run as institutions improve.

        Our study builds up on the work pioneered by Henry (2000a), which studies the behavior

of equity prices around the time of the opening of stock markets to foreign investors, and on the

research initiated by Bekaert and Harvey (2000), who construct a detailed chronology of

financial liberalization with a focus on stock markets. There are five primary contributions of

our research to the existing research. First, we characterize the cycles in stock markets around

the time of deregulation. The study of cycles is important because the literature argues that large

booms and busts in financial markets are at the heart of the crises that occur following financial

liberalization. Second, the previous analysis does not concentrate on the possible time-varying

effects of liberalization.2 This is instead the focus of our paper. Third, we also examine the

dynamics of reforms and liberalization using a variety of measures on the quality of institutions,

as well as data on the laws governing the proper functioning of financial systems. As far as we

know, this is the first paper to study empirically the relation among these variables. Fourth,

while previous work focuses on emerging markets, we also include as a benchmark fourteen

2
 Henry (2000a) analyzes the eight-month window leading up to the implementation of a country’s initial stock
market liberalization.

                                                     4

mature economies. Fifth, existing papers tend to study the effects of the opening of the stock

market to foreign investors. But financial liberalization can take many forms. We thus look at

financial liberalization from a broader perspective. We construct a novel data set on financial

deregulation that includes the opening of the stock market to foreign investors as well as the

deregulation of the domestic financial sector and the opening of the capital account in twenty-

eight emerging and mature markets since 1973. This database complements the well-known

chronologies by Bekaert and Harvey (2002), Quinn and Inclán (1997), and the International

Monetary Fund (IMF).

       We find that liberalization leads to more pronounced booms in the short run than in the

long run in all countries in the sample. We also find that price appreciation is followed by larger

crashes in emerging markets, which supports the view that liberalization might lead to large

booms and crises. The effects are of first order: both booms and busts increase by about 35

percent following financial liberalization (even after controlling for macroeconomic

fundamentals). Our findings for mature markets support the view that liberalization leads to a

sustained increase in the value of firms. In this case, liberalization is followed by larger booms

but not larger crashes. In fact, downturns are substantially smaller (about 20 percent smaller

than before liberalization).   Interestingly, if liberalization persists, financial cycles in both

emerging and mature economies become less pronounced in the long run, with cycles even

declining by about 20 percent from their average amplitude during financial repression.

       The dynamics of liberalization and institutional reform we document may help explain

the above results. In the case of emerging markets, we find that only a few episodes of

liberalization (18 percent) are preceded by improvements in government institutions.           But

financial liberalization seems to unleash government reforms. By the time liberalization is

                                                5

completed (66 months on average after the liberalization process starts), institutional reforms

have already occurred in about 64 percent of the cases. As the quality of institutions improves,

financial cycles become less pronounced perhaps due to the reduction in agency and other

problems. The evidence for mature economies indicates that law and order improve even before

financial liberalization starts in about 50 percent of the cases, possibly explaining why

liberalization is not followed on average by financial crashes. In fact, our econometric results

indicate that improvements in law and order lead to a decline of up to 18 percent in the amplitude

of financial cycles.

       The rest of the paper is organized as follows. Section I describes the new chronology on

de jure financial liberalization for twenty-eight countries since 1973. Section I links our de jure

measure of financial liberalization to financial cycles. Section II studies the relation between

financial liberalization and the time-varying behavior of financial cycles. Section III examines

the dynamics between financial liberalization and institutional reform. Section IV concludes.

I. The Evolution of Global Financial Liberalization

       One of the most prolific areas of empirical research in international economics and

finance has been that of the analysis of the effects of capital controls and financial liberalization

on financial markets, investment, and growth. In spite of the great interest of several disciplines

on the effects of deregulation of financial markets, the information on the evolution of de jure

financial regulations is still fragmented.

       Information on capital account controls is mostly based on indicators published by the

IMF in Exchange Arrangements and Exchange Restrictions. This publication only identifies two

capital account regimes: a “no controls” regime, which includes episodes with full liberalization

                                                 6

of the capital account, and a “controls” regime, which includes both episodes with minor

restrictions to the free flow of capital as well as episodes with outright prohibition of all capital

account transactions. To capture the intensity of controls, Quinn and Inclán (1997) construct two

variables that reflect the degree of capital account and current account openness for twenty-one

members of the Organization for Economic Cooperation and Development (OECD) for 1950-88.

       Information on regulations of the domestic financial sector is even more fragmented.

There is no institution compiling systematic cross-country information over time and researchers

have constructed their own liberalization chronology. For example, Williamson and Mahar

(1998) date liberalization based on the existence of credit controls, controls on interest rates,

entry barriers to the banking industry, government regulation of the banking sector, and

importance of government-owned banks in the financial system. Other efforts include those of

Demirguc-Kunt and Detragiache (1999), who date liberalization for fifty-three countries since

1980. In that study, liberalization of the domestic financial sector is interpreted as liberalization

of domestic interest rates. More recently, Bekaert, Harvey, Lundblad, and Siegel (2004) use

different sources to determine the liberalization on restrictions on foreign banking.

       Information on the liberalization of domestic stock markets is also still partial. The

International Financial Corporation (IFC) provides this information just for emerging markets.

Again, this index only captures two regimes: a “liberalization” regime and a “restricted” regime.

The liberalization dates are determined based on whether foreigners are allowed to purchase

shares of listed companies in the domestic stock exchange and whether there is free repatriation

of capital and remittance of dividends and capital gains. Bekaert and Harvey (2000) improve

over the IFC measure by also including other indicators of deregulation of the stock market, such

                                                 7

as the establishment of new investment vehicles like country funds and depositary receipts. An

updated version of their chronology is available in Bekaert and Harvey (2002).3

         Our chronology complements these previous studies of the evolution of financial

liberalization in various ways. First, our chronology includes deregulation episodes in both

developed and developing countries. Most previous studies focus on emerging markets, perhaps

because most concerns are associated with liberalization episodes in those countries, with even

the most averse critics of capital account liberalization still supporting financial deregulation in

mature markets.4 Second, our chronology deals with the deregulation in the capital account, the

domestic financial sector, and stock markets. Most previous studies have tended to focus on the

elimination of controls in just one particular financial sector. This focus on the opening of just

one financial market may give an incomplete picture of the effects of regulation since controls in

one sector can also affect the behavior of other parts of the financial system, which may or may

not be directly under any type of restrictions.5 Third, our database captures the intensity of

financial liberalization.        Most chronologies do not tend to distinguish between different

intensities of liberalization/repression.6 Since deregulation usually changes slowly, valuable

3
  There is a very large related literature that studies the extent of de facto financial and economic integration from
observable economic variables, not from de jure government regulations. See, for example, Frankel (2000),
Obstfeld and Rogoff (2001), Bekaert, Harvey, and Lumsdaine (2002), Edison and Warnock (2003), and Obstfeld
and Taylor (2003).
4
  An exception is Quinn and Inclán (1997), who construct an index of current and capital account liberalization for
twenty-one OECD countries.
5
  This problem may be particularly important because the complete deregulation of financial systems is not
accomplished in just one round and the time span between the deregulation of one market and the elimination of
controls across the board takes, in most cases, several years. For example, the data show that, in the 1970s,
domestic financial repression is widespread not only in emerging markets, but also in several mature financial
markets. Governments start lifting the various restrictions gradually. In many cases, the liberalization reform starts
in the banking sector with the deregulation of domestic interest rates. The elimination of interest rate controls not
only affects the market for bank loans and deposits, but also attracts international capital flows (when these flows
are not strictly prohibited). Also, the stock market flourishes as the extent of credit rationing diminishes.
6
  Again, Quinn and Inclán (1997) is a clear exception. These authors construct an index of current and capital
account restrictions that allows for different intensities of repression. For each transaction, they create an indicator
with three values, 0, 1, 2, according to whether the transaction is allowed without restrictions, with some restrictions,
or the transaction is simply prohibited. However, since the authors do not attempt to identify the exact
characteristics of the intermediate regime beyond the fact that there are some restrictions, it is unclear whether this

                                                           8

information might be lost when the indicators only try to assess whether or not the liberalization

has occurred.7 Finally, our database captures reversals of financial liberalization. Most previous

chronologies analyze financial liberalization episodes as if they were permanent. Still, many

countries have undergone several liberalization reversals, particularly following currency crises.8

A. New Measures of Financial Liberalization

         To construct the various measures of financial liberalization we use a wide range of

sources, including information provided by both international and domestic institutions. The

information comes not only from cross-country reports, but also from large number of country

studies. Regarding international institutions, we use data from publications of the Bank for

International Settlements, the International Finance Corporation, the International Monetary

Fund, the Organization for Economic Cooperation and Development, and the World Bank. On

the domestic side, we obtain data from annual reports by the central bank, the ministry of

finance, and the stock exchanges of all the countries in our sample. We also use reports by the

Economist’s Intelligence Unit.

intermediate regime has similar characteristics across time and countries. In contrast, our chronology is based on a
clearly defined indicator for each type of transaction, allowing us to compare experiences of partial liberalization
across countries and time. For example, we classify international borrowing by banks and corporations as partially
liberalized when banks and corporations are allowed to borrow abroad but subject to the following restrictions:
reserve requirements on foreign loans are between 10 and 50 percent or the required minimum maturity of the loan
is between two and five years.
7
  For example, Chile introduces restrictions on capital inflows at the beginning of the 1990s. Controls are reinforced
in the mid-1990s in the midst of the capital inflow episode. In 1998, under the threat of a contagious speculative
attack against the Chilean peso, controls are eliminated. Similarly, domestic financial deregulation may take several
years to be complete. For example, the deregulation of the domestic banking sector in Colombia is initiated in
August 1974. Only in the 1980s, credit controls are finally eliminated.
8
  For example, Argentina implements a broad liberalization of financial markets in 1977, which is later reversed in
1982. Again, in the late 1980s, a new wave of financial liberalization affects the domestic financial sector, the
capital account, and the stock market. This time around the liberalization attempt is longer lasting. Still, again in
2001, in the midst of Argentina’s crisis, the government reintroduces controls on interest rates and restrictions on
capital account transactions.

                                                          9

The new database includes twenty-eight countries since 1973.9 We classify the sample

into four (mostly regional) country groupings: the G-7 countries, which are comprised of

Canada, France, Germany, Italy, Japan, United Kingdom, and the United States; the Asian

region, which includes Hong Kong, Indonesia, Malaysia, the Philippines, (South) Korea, Taiwan,

and Thailand; the European group, which excludes those countries that are part of the G-7, and

includes Denmark, Finland, Ireland, Norway, Portugal, Spain, and Sweden; and the Latin

American sample, which consists of the largest economies in the region, Argentina, Brazil,

Chile, Colombia, Mexico, Peru, and Venezuela.

        To capture the liberalization of the capital account, we evaluate the regulations on

offshore borrowing by domestic financial institutions, offshore borrowing by non-financial

corporations, multiple exchange rate markets, and controls on capital outflows. The first two

indicators reflect restrictions on capital inflows. Restrictions on capital inflows can take various

forms, with the most extreme restriction being an outright prohibition to borrow overseas.

Milder controls include restrictions of minimum maturity on capital inflows and non-interest

reserve requirements on foreign borrowing.

        To measure the liberalization of the domestic financial system, we analyze the

regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign-

currency deposits. Since monetary authorities in emerging economies often use changes in

reserve requirements to control banking credit, we also collect data on reserve requirements as

additional information to evaluate the degree of restrictions imposed on the banking sector. To

set the liberalization dates, we focus mainly on the first two variables, the price indicators.

However, we complement that information with the regulations on the last three variables, those

9
  In fact, since Hong Kong and Taiwan are part of China, the database has fewer countries. Still, for simplicity we
refer to those economies as countries.

                                                        10

on quantities, to have a better grasp of the degree of repression of the domestic financial sector.

Finally, to track the liberalization of stock markets, we study the evolution of regulations on the

acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and

repatriation of interest and dividends. Part of these regulations on stock market indicators have

already been documented by Bekaert and Harvey (2000) for some of the countries in our sample.

        For each sector, our chronology identifies three regimes: “fully liberalized,” “partially

liberalized,” and “repressed.” The criteria used to determine whether the capital account, the

domestic financial sector, and the stock market are fully or partially liberalized, or repressed, are

described in detail in the Appendix Table 1. We established these criteria after collecting all the

regulations and carefully studying the range of restrictions implemented in all the countries in the

sample since 1973. We believe that these criteria characterize well the degrees of financial

liberalization. The chronology of restrictions compiled for each country and sector along with

the complete list of references used to construct it are described in separate Annex Tables 1 and

2, available upon request.10

        Table 1 reports the dates of partial and full financial liberalization for all the countries in

the sample. The first three columns of dates display the liberalization of the capital account, the

domestic financial sector, and the stock market. The last two columns report dates of partial and

full liberalization taking into account the three sectors analyzed. A country is considered to be

fully liberalized when at least two sectors are fully liberalized and the third one is partially

liberalized. A country is classified as partially liberalized when at least two sectors are partially

liberalized.

10
  This information is reported in Annex tables to eventually separate them from the rest of the paper to make it
shorter.

                                                      11

B. Pace and Dynamics of Liberalization

       Figures 1-3 and Table 2 summarize the information in Table 1 by displaying the time-

series and cross-sectional variation of liberalization.    Figure 1 plots the index of financial

liberalization in emerging and mature markets. This index jointly evaluates the liberalization of

the capital account, the domestic financial sector, and the stock market. It can take values

between one and three, with one indicating fully liberalized and three indicating fully repressed

financial systems. As expected, mature financial markets are on average less regulated. The

index for mature markets averages 1.7 over the sample, while for emerging markets, it averages

2.3. Across all regions there is a gradual lifting of restrictions, with the index of liberalization

declining from an initial value of 2.5 for mature markets and 2.9 for emerging economies to one

and 1.2, respectively, toward the end of the sample. Still, there is also a regional pattern in the

dynamics of financial liberalization, with emerging markets suffering liberalization reversals in

the early 1980s, following the debt crisis. In contrast, the pace of liberalization in mature

markets, while also gradual, is uninterrupted.

       Figures 2 and 3 examine separately the sequencing of liberalization of the capital

account, the domestic financial sector, and the stock market. Figure 2 shows the index of

liberalization for each sector for both emerging and mature markets. Stock markets in developed

countries are liberalized earlier, with the index for this sector oscillating around 1.5 in the early

1970s. In contrast, both the domestic financial sector and the capital account tend to be severely

repressed until the early 1980s. In the early 1970s, the indexes for both sectors are on average

above 2.5. Financial markets across the board are heavily repressed in developing countries in

the early 1970s. But in the mid and late 1970s, many emerging economies liberalize the

domestic sector and the capital account. The liberalization reform is short lived. Controls are re-

                                                 12

imposed in the aftermath of the 1982 debt crisis. Overall, restrictions in stock markets remain in

place until the late 1980s when a liberalization wave occurs in Asia and Latin America.

       While Figure 2 provides information on the average level of restrictions in the various

financial markets in the two regions, it may still mask individual country experiences. For

example, a medium value of the index in one region may reflect that all the countries in that

region are partially liberalized, or that some countries are fully liberalized while the rest of the

countries are completely repressed. Figure 3 presents another perspective of the sequencing of

liberalization across countries. This figure reports the proportion of countries with (at least)

partial liberalization of the capital account, the domestic financial sector, and the stock market,

again examined separately for emerging markets and mature markets. By the early 1970s, about

80 percent of stock markets in mature markets are already liberalized. In mature markets, the

liberalization of the domestic financial sector also predates the opening of the capital account,

with about all countries liberalizing, at least partially, the domestic financial sector by the mid

1980s. It is only in the late 1980s and the beginning of the 1990s, in part driven by the

movement toward the formation of the European Monetary Union, that capital account

liberalization reaches all mature markets.

       Liberalization follows a more volatile path in emerging markets. Only a small proportion

of countries implement reforms before the early 1970s. This proportion increases in the late

1970s and then again in the mid and late 1980s. By early 1990s, all the sectors of the financial

system are finally liberalized. There are two episodes of financial liberalization. The first one is

in the late 1970s. In this episode, all the action centers in the domestic sector and the capital

account, with the stock market continuing to be out of the reach for foreign investors. This

liberalization episode ends following the debt crisis in 1982. The second wave of liberalization

                                                13

starts in the late 1980s. This time around, basically both the domestic sector and the stock

market are jointly deregulated, predating capital account liberalization that only starts in the early

1990s.

         Table 2 examines even further the sequencing of liberalization by analyzing the strategies

and duration of liberalizations in Asia, Europe, G-7 countries, and Latin America. The top two

panels show the proportion of episodes in which the capital account, the domestic financial

sector, or the stock market is liberalized first. The top panel focuses on partial liberalization

episodes; the panel below examines full liberalization episodes. The bottom two panels display

the duration of liberalization episodes; they report the number of months from the time the first

market is deregulated until liberalization is implemented in all markets. The top two panels

reveal that the paths toward financial reform differ across regions.            Basically all the G-7

countries deregulate the stock market first. European countries implement a somewhat mixed

strategy toward deregulation, with 25 percent of the countries liberalizing the domestic financial

sector first and basically all the rest deregulating the stock market first. On the other hand, Latin

American countries overwhelmingly adopt liberalization of the domestic financial sector first,

while Asian countries follow a mixed strategy, with some countries opting for deregulating the

domestic sector first and some others focusing on the stock market first. Capital account

liberalization in all Asian countries is mostly introduced at a latter stage.

         The bottom panels reveal that liberalization reforms take a long time to be completed.

On average, 66 months elapse from the time the first market is liberalized until all markets are

deregulated. It is worth noting that the time to completion of the liberalization reform is far

longer in Asia than in Latin America. Finally, liberalization episodes that are first implemented

in the stock market are the ones that become completed the fastest. The variety of experiences in

                                                  14

financial reforms indicates that it is important to examine not just the responses to liberalization

in one particular financial market, but also the effects of the sequencing of deregulation.

II. Stock Market Cycles and Financial Liberalization

       This section examines the effects of financial liberalization on booms and busts in stock

prices. We are interested in quantifying the effects of liberalization on the amplitude of financial

cycles and to examine whether these effects are of a permanent nature. To do so, we need first to

identify financial cycles. There are various techniques to extract fluctuations at business cycle

frequencies. The most well known are the Hodrick-Prescott (1997) filter, the Baxter and King

(1995) band-pass filter, and the NBER methodology, which is associated with the official

chronology of expansions and contractions in the United States. In this paper, we use the NBER

methodology, which can be replicated using an algorithm that identifies local maxima subject to

constraints on the minimum duration of the cycle. Importantly, before proceeding with our

analysis of the effects of financial liberalization on booms and busts in stock prices, we need to

check whether stock prices follow random walks. If stock prices follow random walks, as the

theory of efficient markets would predict, the identified cycles using any of the filters would be

spurious. Thus, using Monte Carlo simulations, we first test that that the random walk does not

capture the basic properties of our data on stock prices. Since we reject the random walk

hypothesis at all conventional significance levels, we continue with our study of the

characteristics of stock price cycles in the twenty-eight countries in the sample. The description

of the methodology, the identification of the cycles for each country in the sample, and the tests

against the random walk hypothesis are described in Appendix I.

                                                 15

A. Characteristics of Stock Market Cycles

       This section examines the characteristics of stock market cycles for the various regions.

We identify 146 cycles with an average duration of about 44 months. Figure 4 shows the

characteristics of the typical cycle in the Asia, Europe, G7, and Latin America. The top panel

reports the mean amplitude and duration of booms and crashes in the four regions, while the

bottom panel plots the typical cycle in each region. The horizontal axis in the bottom panel

shows the number of months before and after the peak of the cycle. The horizontal axis contains

26 months for expansions and 18 months for contractions. These are the durations of the two

phases for the typical cycle in our sample. The vertical axis reports the value of the stock index.

To obtain the typical cycle, the value of the stock index in each cycle is normalized to 100 at the

peak. Each line in this panel represents the average value of the stock index during the 44

months around the peaks of the four regions. Cycles are more pronounced in Latin America. On

average, the amplitude of cycles in this region is about twice as large as the amplitude of cycles

in the G-7 countries. As expected, the most developed countries, the G-7, have milder stock

market cycles, with the Asian and the other European stock market cycles being of intermediate

magnitudes.

       We now turn to the analysis of the effects of liberalization on the characteristics of

financial cycles. To examine the conflicting views on the effects of financial liberalization, we

compare the characteristics of financial cycles in the short and long run, following the

deregulation of financial markets. Our first approach is in the event study tradition, analyzing

the behavior of stock markets in the aftermath of liberalization relative to their functioning in

repression times, those years before deregulation occurs. We then report regression results that

control for other factors and study the sequencing of the openings. Those results examine

                                                16

whether liberalization creates larger cycles when the first market opens or whether each

consecutive opening triggers substantial increases in booms and crashes. The regressions also

test whether large financial cycles are just the product of liberalization episodes that start with

opening first the capital account, the domestic sector, or the stock market.

B. Event Studies

        Figure 5 examines the characteristics of financial cycles around the time of the overall

partial liberalization of financial markets, that is, when at least two sectors are partially

liberalized. We classify financial cycles in three categories, those that occur during repression

times, those that occur in the short run after liberalization, and those that occur in the long run

following liberalization. The short run is defined as the four years after liberalization. The long

run includes the fifth year after liberalization and the years thereafter, conditional on the

deregulation not being reversed.11 The top panel in Figure 5 shows the average amplitude of

booms and crashes for all countries in our sample during repression times (the striped bars), in

the short run following liberalization (the white bars), and in the long run after liberalization (the

gray bars). It also reports the characteristics of cycles separately for emerging and mature

markets since the evidence from these two groups of countries might differ. The bottom panel

examines whether the differences of amplitudes across regimes are statistically significant.

        The evidence for the twenty-eight countries in the sample indicates that the amplitude of

booms substantially increases in the immediate aftermath of liberalization (about 20 percent

higher than during repression times). But equity markets stabilize in the long run if liberalization

persists, with the amplitude of booms about 25 percent smaller than in repression times.

11
  Since the choice of the short-run window is ad-hoc, we also examined the robustness of the results to different
definitions of window size. The results for three- and six-year windows are quite similar.

                                                       17

Similarly, the amplitude of crashes increases in the immediate aftermath of liberalization (about

15 percent higher than during repression times), but declines to about 60 percent of its size

during repression times if liberalization persists in the long run. As shown in the bottom panel,

these differences are statistically significant at conventional levels.

        The evidence for the twenty-eight countries, however, obscures important differences

across emerging and mature markets. The short-run effects of liberalization in emerging markets

are more pronounced, with booms and crashes in the immediate aftermath of liberalization

increasing by about 35 percent over their size during repression. Still, if liberalization persists,

financial cycles become less pronounced, with booms about 30 percent smaller than during

repression times, and crashes about 90 percent of their size during repression times. On the other

hand, the evidence from mature markets indicates that if liberalization triggers more volatile

stock markets in the short run, booms and busts do not increase as much as in the case of

emerging markets. Moreover, on average, crashes do not increase relative to their value during

repression times. Still, liberalization seems to generate more stable financial markets in the long

run, with crashes averaging only about 60 percent of their size in repression times.

C. Accounting for Domestic and External Shocks

        While the evidence in Figure 5 suggests that financial liberalization influences the size of

expansions and contractions in financial markets, stock price fluctuations also reflect changes in

other market fundamentals. For example, stock prices respond to expansions and recessions in

the domestic economy. They also react to world economic conditions.12 The omission of these

variables may bias our results, especially since the timing of liberalization may also be affected

12
  For example, Calvo, Leiderman, and Reinhart (1993) argue that decreases in U.S. interest rates trigger large
capital flows to emerging markets, which in turn fuel increases in asset prices.

                                                     18

by these factors. In fact, as described in Section I, Latin American countries reintroduce controls

on domestic interest rates and credit and re-impose controls on capital flows following the hikes

in interest rates in industrial countries in the early 1980s.                 Also, many emerging markets

liberalize their financial markets before international capital flows increase, as in the late 1980s.

Insofar as countries react to “bad times” by adopting capital controls and to “good times” by

relaxing them, there is the danger that we may ascribe the increase in the size of booms to

liberalization and the amplification of crashes to capital controls, when in fact it is the world

market condition the one fueling changes in stock prices.

       To account for these factors, the event study analysis is complemented with regressions

that control for domestic and world economic conditions. In particular, we examine the role of

growth in domestic and world economic activity and changes in world real interest rates. We

estimate the following equation by least squares with heteroskedastic-consistent standard errors,

                      amplitudei = α ' Χ i + ρ1d ir + β1d isr + λ1d ilr + ε i ,     (1)

where amplitudei is the amplitude of expansion (contraction) i.                   Χi is a matrix of control

variables that includes the change in world real interest rate, the world output growth, and the

domestic output growth during each expansion (contraction). d ir is a dummy variable equal to

one if the cycle occurs during “repression” times, and zero otherwise.                    d isr is a “short-run”

dummy variable equal to one if the cycle occurs in the immediate aftermath of financial

liberalization (four-year window), and zero otherwise.                d ilr is a “long-run” dummy variable

equal to one if the cycle occurs after four years have elapsed from the time of financial

liberalization, and zero otherwise. The world real interest rate is proxied with the U.S. federal

funds real interest rate, world output is the average of the industrial production indexes of the G-

                                                       19

3 countries, and domestic output is captured by the index of industrial production in the domestic

economy. All data come from the IMF’s International Financial Statistics.

       The results from this estimation are shown in Table 3. As in Figure 5, this table

examines the effects of overall partial financial liberalization (when at least two sectors have

been partially liberalized). As expected, fluctuations in the world interest rate affect stock

market cycles and output growth, with a one percentage point increase in the world real interest

rate leading to a five percentage point contraction in the amplitude of stock market expansions.

Similarly, booms and crashes in stock markets are also explained by upturns and recessions in

the domestic economy. Even after accounting for these other determinants of fluctuations in

stock prices, financial liberalization still matters. Financial liberalization triggers larger cycles in

the short run and stabilizes financial markets in the long run. Once we control for the state of the

economy (domestic and foreign) and for interest rate fluctuations, the short-run effects of

financial liberalization become even more pronounced. For example, in the immediate aftermath

of liberalization, booms increase by about 40 percent in emerging markets and by 55 percent in

mature markets relative to repression times. Similarly, crashes in emerging markets increase by

30 percent in the immediate aftermath of liberalization vis-à-vis repression times.

       Note that the results in Figure 5 and Table 3 suggest two different patterns in the

aftermath of liberalization. While larger booms follow liberalization in both emerging and

mature markets, it is only in emerging markets that crashes are more severe following

liberalization. The average short-run experience in emerging markets seems to support the

evidence from the crisis literature that concludes that liberalization is associated with excessive

financial booms and crashes. Liberalization episodes do not seem to bring (on average) this

short-run pain to mature markets. In those economies, larger booms are not followed by larger

                                                  20

crashes, suggesting that larger booms may just reflect the reduction in the cost of capital once

deregulation takes place, as the neoclassical theory indicates.13 Still, financial liberalization is

related to more stable financial markets in both emerging and mature market economies in the

long run.

D. Sequencing of Liberalization

        So far we have studied the liberalization across all markets. Now we turn to examine

whether the short-run increase in boom-bust amplitudes occurs every time a new sector is

deregulated and whether the sequencing of the openings matters. Table 4 examines whether the

short-run increase in booms and busts occurs every time a new sector is deregulated. We limit

our search to the deregulation of the first two sectors. We define repression times as those

episodes in which all sectors are closed. The short-run liberalization periods are the four years

after the opening of the first sector and the four years after the opening of the second sector. The

long-run liberalization episode includes the fifth year after the opening of the second sector and

the following years if the liberalization reform is not reversed.

        We estimate the following regression,

                   amplitudei = α' X i + ρ1d ir + β1d isr ,1, 2 + β 2 d isr , 2 + λ1d ilr , 2 + ε i . (2)

The new variable d isr ,1, 2 is a dummy variable equal to one if the cycle occurs in the immediate

aftermath of financial liberalization (four-year window after the first sector is deregulated and

four-year window after the second sector is deregulated), and zero otherwise. d isr , 2 is a dummy

variable equal to one if the cycle occurs in the four years after the deregulation of the second

13
  As always averages may hide exceptions, Denmark, Finland, Norway, and Sweden suffer financial collapses and
banking crises in the early 1990s following liberalization.

                                                            21

sector, and zero otherwise. d ilr , 2 is a dummy variable equal to one if the cycle occurs after four

years have elapsed from the time of the liberalization of the second sector, and zero otherwise.

Thus, the average amplitude of booms (crashes) in the aftermath of the first opening is captured

by β1 , while that of the second market opening is captured by β1 + β 2 .

        While the evidence on short-run and long-run effects of financial liberalization is not

reversed, the focus on the first and second openings reveals some important differences. The

increase in the amplitude of booms is similar following the first and second opening, but crashes

in the immediate aftermath of the first opening are smaller than those observed during repression

times. The amplitude of crashes in emerging markets only increases following the opening of

the second sector. Again, this evidence is consistent with the results from the crisis literature,

which finds that booms of credit persist for several years following the deregulation of financial

markets with these booms in turn fueling protracted bull markets.

        Table 5 examines the effects on financial markets of various types of sequencing of the

deregulation process. We estimate the following regression,

       amplitudei = α' X i + ρ1d ir + β1d isr ,1, 2 + β 2 d isr , 2 + β 3d iCA + β 4 d iSM + λ1d ilr , 2 + ε i .   (3)

The variables d iCA and d iSM capture the possible differential effect on booms and crashes from

opening respectively the capital account and the stock market first. These dummy variables are

equal to one if the cycle occurs during the four years after that particular sector is liberalized, and

zero otherwise. The average amplitude of booms (crashes) in the aftermath of the first opening,

when the liberalization reform is initiated with the deregulation of the domestic financial sector,

is captured by β1 . If the liberalization reform starts with the opening of the capital account

(stock market), the amplitude of booms or crashes in the four years after the first opening is

captured by β 1 + β 3 (β 1 + β 4 ) .

                                                                22

Our results indicate that the ordering of liberalization does not matter in general.

Opening the capital account or the stock market first does not have a different effect than

opening the domestic financial sector first. But one exception exists; crashes seem to be larger in

emerging markets if the capital account opens up first. This might provide some mild support to

the usual claim that the capital account should be opened last.

        In sum, our results suggest that we gain from examining the effects of deregulation of

different sectors. In particular, we find that crashes become more pronounced not at the onset of

the liberalization reform but after some years have elapsed. Interestingly, the sequencing of

financial liberalization does not seem to matter when evaluating the effects on financial cycles.

Finally, as also shown in the previous section, the experiences of mature and emerging markets

look different in the aftermath of financial liberalization. We analyze these differences next.

III. Financial Liberalization and Institutional Reform

        In this section, we complement the results above by returning to the discussion on the

links between financial liberalization and institutional reform summarized in the Introduction.

The argument that liberalization should be preceded by institutional reforms may be irrelevant if

the timing is such that reforms never predate liberalization, with institutional changes happening

mostly as a result of financial deregulation. To shed new light on this debate, we compare the

timing of financial liberalization and institutional reforms.14 To so, we collect data on the quality

of institutions as well as on the laws governing the proper functioning of financial systems. The

information on the quality of institutions is captured by the index of law and order. This index is

published in the International Country Risk Guide (ICRG). The law sub-index assesses the

14
   Chinn and Ito (2005) and Tornell, Westermann, and Martinez (2003) study at the relation between capital account
liberalization and trade liberalization and find that the latter precedes the former.

                                                       23

strength and impartiality of the legal system, while the order sub-index assesses the popular

observance of the law. Each index can take values from one to three, with lower scores for less

tradition for law and order. To better assess the functioning of the financial system, we use

information on the existence and enforcement of insider trading laws, constructed by

Bhattacharya and Daouk (2002). Table 6 reports the time of improvement in the law and order

index, the time when the insider trading law is passed, and the time when insider trading starts to

be prosecuted. We characterize as an improvement in the quality of government institutions

when the index of law and order increases by one unit and this change is maintained for at least

two years.

       The top panel in Table 7 examines the sequencing of liberalization and reform in our

sample of twenty eight countries. It shows the probabilities that financial liberalization occurs

conditional on reforms having already been implemented. In particular, we look at whether

reforms to institutions occur prior to the partial or full liberalization of the financial sector. If

governments improve the quality of institutions prior to start deregulating the financial sector,

one would expect the probability of partial liberalization conditional on improvements in

institutions to be close to one. In contrast, if liberalization triggers reforms, those probabilities

would be close to zero. In this case, we would also expect the probabilities of full liberalization

conditional on reforms to institutions to be close to one since full liberalization on average occurs

after five and a half years following the start of financial deregulation.

       As shown in Table 7, the dynamics between reforms and financial liberalization in

emerging and mature economies differ somewhat. In the case of emerging markets, reforms to

institutions occur mostly after financial liberalization starts. Institutions that protect property

rights, as captured by the index of law and order, only improve in 18 percent of the cases prior to

                                                  24

the partial liberalization of financial markets. Similarly, institutions that facilitate contracting

between citizens, as captured by insider trading prosecution laws, seem also to improve after

financial liberalization starts. For example, while in 62 percent of the cases laws prosecuting

insider trading exist prior to the start of financial liberalization, insider trading only starts to be

prosecuted in 11 percent of the cases. Interestingly, both the institutions that protect property

rights and those that regulate contracting improve substantially following the partial

liberalization of financial markets. By the time the financial sector becomes fully liberalized (on

average about five and a half years from the beginning of the deregulation episode), law and

order have improved in 64 percent of the cases and insider trading prosecution is now enforced

in 44 percent of the cases. This evidence casts doubts on the notion that governments in

emerging markets tend to implement institutional reforms before they start deregulating the

financial sector. On the contrary, the evidence suggests that liberalization fuels institutional

reforms as suggested by Mishkin (2003) and Stulz (1999 and 2005).

       The dynamics between reforms and financial liberalization is different in mature

economies. By the time that financial liberalization starts, institutions that protect property rights

are already in place in 44 percent of the cases. In contrast, reforms that regulate contracting

between citizens are not in place when liberalization begins. In only 17 percent of the cases

prosecution of insider trading is implemented prior to the partial liberalization of the financial

sector. In statistical terms, financial liberalization does not seem to fuel further improvements in

institutions in those countries still lacking good property rights protection or prosecution of

insider trading.

       These varied intrinsic dynamics between institutional reform and financial liberalization

in developed and developing countries may be the key to explain our findings on financial cycles

                                                  25

following financial liberalization.                  As financial liberalization predates improvements in

institutions in emerging markets, it may trigger excessive booms and busts in financial markets

(in the short run) due to a variety of problems, such as the agency ones suggested by Stulz

(2005). But liberalization triggers reforms and sows the seeds of the destruction of old protected

financial system, with capital markets becoming more stable in the long run. In contrast,

distortions in financial markets in developed economies may be less pervasive at the time of

liberalization because institutional reforms precede deregulation. With more efficient financial

markets, liberalization fuels increases in productivity and in the value of firms, but not financial

collapses.

       To capture the effects of changes in institutions on financial booms and busts, we

estimate the following regression,

             amplitudei = α ' Χ i + ρ1d ir + β1d isr + λ1d ilr + τ 1d iL & O + τ 2 d iITA + τ 2 d iITE + ε i .   (4)

This regression is the same as regression (1) but also evaluates the possible effects of changes in

government institutions. d iL & O is a dummy variable equal to one if the boom (crash) occurs

when the law and order index has improved or is at its highest level, and zero otherwise. d iITA is

a dummy variable equal to one if the boom (crash) occurs following the approval of the law

prosecuting insider trading, and zero otherwise. d iITE is a dummy variable equal to one if the

boom (crash) occurs when insider trading prosecution is enforced and zero otherwise.

       The results reported in the bottom panel in Table 7 indicate that improvements in law and

order do indeed trigger more stable financial markets, with the amplitude of booms and crashes

declining about 18 and 9 percentage points (respectively) following government reforms.15 This

result suggests one possible explanation to why mature markets, with better government

                                                                26

institutions, do not experience the larger crashes observed in emerging markets in the aftermath

of liberalization. In contrast, insider trading laws (existence or prosecution) do not seem to have

any impact on the amplitude of financial cycles.

           Our findings on the effects of various types of institutions on financial cycles support the

Acemoglu and Johnson (2003) hypothesis that the role of contracting institutions is of a more

limited nature than that of property rights institutions. They argue that societies can function in

the face of weak contracting institutions without first order costs, but have a much harder time

dealing with a significant risk of expropriation from the government. The idea is that individuals

often find ways of altering the terms of their formal and informal contracts to avoid the adverse

effects of contracting institutions, but are unable to do so against the risk of expropriation. It is

in those last cases, when law and order institutions are weak, that agency problems become more

pervasive and, we should add, financial cycles may become more pronounced as suggested by

the literature on crises.

IV. Conclusions

           This paper makes progress on the literature on financial liberalization. First, it examines

the possible time-varying effects of financial liberalization on financial markets. By analyzing

the short- and long-run effects, our results help to reconcile, at least in part, the conflicting

empirical evidence on the effects of financial liberalization. Our estimations explain both the

link between liberalization and crises as well as the relation between deregulation and financial

market development.              Second, it provides new empirical evidence on the dynamics of

government institutional reforms and financial liberalization. The fact that reforms tend to take

place after liberalization can help in understanding the short-run pain and long-run gain

15
     Still, the effects on financial crashes are more imprecisely estimated that those on financial booms.

                                                            27