Financial Liberalization and Crises in Transition Economies: What Have 20+ Years Taught Us?

Financial liberalization in transition economies has facilitated the creation of market economies, but it also has exposed countries and their real economies to volatility from international financial markets. With uneven financial liberalization across the transition space, a key question is, does financial liberalization unduly expose countries to crises, or does a liberalized financial sector help countries to weather crises better they would have otherwise? Using a database of 28 transition economies from 1989-2010 compiled from World Bank and Global Insight data, we examine the performance of several economic indicators (including private sector share of GDP, per capita savings, FDI inflows, and fixed capital formation) in periods of crisis as a function of financial sector liberalization and other institutional factors. Using fixed-effects, GLS, and GMM estimators, results show a strong correlation between banking reform and/or financial openness and positive economic outcomes, even during crisis periods. The complete results should point to the fact that while liberalization and integration in international financial markets carries a risk of contagion, the benefits of liberalization outweigh these risks; more importantly, liberalization can help to moderate the effects of a crisis if and when it does strike.