Financial Globalization and Emerging Markets: With or Without Crash?

We analyze the impact of financial globalization on asset prices, investment and the possibility of crashes driven by self-fulfilling expectations in emerging markets. In a two-country model with one emerging market (intermediate income level) and one industrialized country (high income level), we show that liberalization of capital flows increases asset prices, investment and income in the emerging market. However, for intermediate levels of international financial transaction costs, we find that pessimistic expectations can be self-fulfilling, leading to a financial crash. The crash is accompanied by capital flight, a drop in income and investment below the financial autarky level and more market incompleteness. We show that emerging markets are more prone to financial crashes simply because they have a lower income level and not because of the existence of market failures (moral hazard or credit constraints), bad monetary policies or exchange rate regimes.