1. Introduction
Financial globalization has resulted in the greater availability of liquidity
in international capital markets and this has led to various booms, and busts, in capital
flows. For example, new capital became available following the oil boom of the
1970s, when the accumulation of so-called petrodollars made international banks
highly liquid and eager to finance public debt in emerging markets, most notably in
Latin America. Financial liberalisation and the capital flows of the 1970s and early
1980s preceded the debt crisis that started in Mexico in 1982. To solve this crisis, and
instrumental for the development for emerging markets’ bond markets, sovereign debt
was securitize with the Brady Plan. Industrial countries since the 1970s have pursued
policies of fiscal consolidation and sovereign debt has been less dependent upon
capital flows (see Hauptmeier et al. 2006, and Favero and Giavazzi, 2007). In
contrast, there is a close link between financial globalization and the fiscal
sustainability of emerging market economies: emerging markets rely on foreign
capital inflows to finance sovereign debt.1
A troublesome aspect of financial globalization is that it has coincided
with a high degree of instability, both of capital flows and domestic financial systems.
Sudden Stops in the availability of external finance due to abrupt changes in investor
sentiment towards emerging markets have greatly increased the vulnerability of these
countries (Calvo, 1998). In particular, the Mexican Crisis 1994, East Asian Crisis of
1997-98 and the Russian Crisis of 1998 revealed the volatile nature of capital flows as
sudden reversals in international capital flows forced painful macroeconomic
1 The emergence of large sovereign wealth funds in particularly Asia as well as the 2007 US subprime
crisis highlight further linkages between financial globalization and fiscal sustainability, which may
well become more apparent in the future. Through sovereign wealth funds in emerging markets are
increasingly taking exposure to corporate risk in industrial countries, which creates a contingent fiscal
liability for the government. The nationalization of the distressed Northern Rock mortgage bank in the
UK in 2007, which was one of the first victims of the subprime mortgage crisis outside the US, created
an off-balance sheet fiscal liability for the UK government.