Fiscal deficits, banking crises and policy reversal in a semi-open economy

We study the effect of domestic policies and external shocks in a semi-open economy characterized by incomplete liberalization of the financial sector. We argue that in such transition economies stabilization programs can have a negative impact on the fiscal imbalances, offsetting to some extent the very achievement of the stabilization program. We develop a simple general equilibrium model which allows propagation of shocks in the presence of government guarantees and imperfect capital mobility. We also empirically test the impact of positive foreign interest shock on the Indian economy using a reduced form VAR approach. The econometric evidence, though broadly consistent with the main predictions of the model, suggests no significant impact of foreign interest rate shock on output and credit. We conclude that incomplete liberalization of the financial sector in transition economies has two effects. It reduces i) exposure to external financial shocks (like the current credit crisis) and ii) ability to deal with real sector shocks (which may arise from global recession in the medium term) due to endogenous policy reversals and presence of government guarantees.

► We develop a general equilibrium model of a semi-open transition economy. ► Gains from stabilization polices can be reversed with worsening fiscal deficit. ► The model is tested using monthly Indian data from April 1990 to October 2010. ► Incomplete financial liberalization reduces impact of external financial shocks. ► Such liberalization increases the economy's vulnerability to real sector shocks.