Financial Stability of a Small Open Economy Under Credit Constraints

Abstract

One of the most visible causes for booms and busts in emerging economies is financial market friction. Some of the features of a small, open, financially developing economy include a fragile financial market, exchange rate shocks, and asset price volatility that often result in credit constraints. Because these shocks accentuate credit cycles of collateral-based bank lending to the non-tradable sector, an emerging economy experiences series of financial booms and busts. In fact, this has been found to be true of such economies to an unvarying degree. The fundamental cause of market fragility is polarization of industrial bases (NT sector) that are increasingly exposed to external shocks. Credit flows cannot be dispersed widely since risk cannot be accommodated by investors without implicit government guarantees. The interaction of implicit bailout guarantees and lack of contract enforceability makes market intervention by the authority a permanent feature of stabilization efforts that often trigger sizable balance sheet effects. For the purpose of securing stability, any serious effort to strengthen market infrastructures via greater access to wider markets must entail governance restructuring to allow the market mechanism to perform its natural function.