Foreign banks and the dual effect of financial liberalization

In emerging countries, credit market liberalization is often motivated with the financial deepening generated by the entry of foreign financial institutions. However, there is a risk that liberalization may benefit internationally active, export-oriented businesses at the expense of domestically oriented ones. This paper models a two-sector economy in which foreign lenders are more efficient than local lenders at extracting value from internationally tradable collateral assets. Under some conditions the entry of foreign lenders eases entrepreneurs’ access to the credit market and raises asset prices and output, but in other circumstances it reduces the depth of the credit market and depresses the price of nontradables and output. Liberalization can have a contractionary impact by inducing a reallocation of credit from the nontradables to the tradables sector.