Capital Market Liberalization and Financial Crises: The Case of Asia

In a number of developing countries, capital market liberalization appears to have been associated with costly financial crises. This paper examines how capital market liberalization can cause financial crises by negatively affecting domestic fundamentals and by facilitating contagion. Data of the Asian Crisis countries show that even though the fundamentals worsened after the capital market liberalization (real appreciation and current account deficits), other factors such as world price shocks are also responsible for weakening fundamentals. Cross-country correlations of macroeconomic variables demonstrate that the possibility of contagion increases as these countries open their capital markets, but only slightly. Finally, we compare the Asian Crisis with the European Crisis in 1992, testing for any common features in the degree of capital market liberalization at the time of crisis. All these results lead to the conclusion that there is no evidence that capital market liberalization directly causes financial crises.