The Development of Financial Intermediation and Real Effects of Capital Account Liberalization

Abstract

We consider lending and investment under asymmetric information in an emerging economy. We allow for different forms of Þnancial contracts to arise endogenously in the credit market. We examine the impact of opening the capital account on both aggregate output level and the structure of lending arrangements. Financial intermediaries mitigate the moral hazard problem in investment choice through costly monitoring all projects and liquidating risky, negative NPV projects. Depending on the quality and cost of the monitoring technology, opening the capital account may strengthen or weaken the role of Þnancial intermediaries, leading to an improvement or worsening of the aggregate composition of investment projects. Our results suggest situations where limiting the capital insow or outsow may be necessary to avoid an aggregate risk shift and the collapse of the Þnancial intermediation sector.