ESSAYS ON INTERNATIONAL FINANCIAL INTEGRATION OF EMERGING MARKET ECONOMIES Patrizia BaudinoA DISSERTATION PRESENTED TO THE FACULTY OF PRINCETON UNIVERSITY IN CANDIDACY FOR THE DEGREE OF DOCTOR OF PHILOSOPHY RECOMMENDED FOR ACCEPTANCE BY THE DEPARTMENT OF ECONOMICSJanuary 2005UMI Number: 315603331560332005Copyright 2005 byBaudino, PatriziaUMI MicroformCopyrightAll rights reserved. This microform edition is protected againstunauthorized copying under Title 17, United States Code.ProQuest Information and Learning Company300 North Zeeb RoadP.O. Box 1346Ann Arbor, MI 48106-1346All rights reserved.by ProQuest Information and Learning Company. c Copyright by Patrizia Baudino, 2005. All Rights Reserved AbstractThis collection of essays explores different ways in which fragile financial structures in emerging market economies (EMEs) expose them to capital account crises. The common thread among the three essays is the fact that weak financial markets can make crises more costly, due to the multiplier effect of financial intermediation and the inherent fragility of financial institutions. In the first essay, a fragmented domestic banking sector in an EME induces local banks to rely excessively on the domestic interbank market to finance their short-term liabilities. As a result, the commitment of the central bank to the tight monetary policy consistent with a fixed exchange rate is not credible and currency speculators can induce a devaluation by short-selling the domestic currency. Hence, the weak domestic financial sector can force the central bank to lose control of the supply of domestic currency. In the second paper, the domestic financial sector is composed of several banks with different, but indistinguishable, levels of profitability. In the event of a large demand for external funds by the EME, this property of the banking sector can induce foreign investors to lend to no domestic bank. In addition, for a dollarized economy, as is usually the case for EMEs, the internal drain that caused the demand for external funds may be accompanied by an external drain. In fact, if the central bank acts as a lender of last resort, it loses control of the exchange rate and it induces a country-wide banking crisis, given the currencymismatches in banks balance sheets. The third essay evaluates a policy choice for EMEs concerning international capital flows, i.e., whether to make controls on capital outflows a standard policy tool to be used at times of capital account crises. The paper focuses on the impact of this policy choice on international investors. Given investors ex-post interpretation of the cause of the crisis, i.e., bad fundamentals in the EME, the choice to use capital controls is shown to discourages capital flows to EMEs and to shift the remaining flows towards shorter maturities. iii AcknowledgementsI am deeply indebted to my advisors, Ben Bernanke, Guido Lorenzoni, Pierre-Olivier Gourinchas and Helene Rey, for their guidance in the preparation of my dissertation. I would also like to thank the Department of Economics at Princeton University, not only for the kind and patient support in the final stages of the preparation of the dissertation, but also for the excellent quality of the courses and the wonderful experience of the PhD studies overall. The Graduate School and the International Economics Section at the Department of Economics offered financial support during the summer of 2001 and 2002 respectively for the dissertation work. iv ContentsAbstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv 1 Introduction 1 2 Regional Banking and Twin Crises: the Effect of an Inefficient Banking Sector on the Likelihood of Currency Attacks 6 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2.2 The basic model of the Economy . . . . . . . . . . . . . . . . . . . . . . . 8 2.2.1 The banking contract . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.2.2 Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 2.3 Currency speculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.3.1 The revised banking contract and monetary policy rule . . . . . . . 22 2.3.2 Exogenous size of the devaluation . . . . . . . . . . . . . . . . . . 26 2.3.3 Endogenous size of the devaluation . . . . . . . . . . . . . . . . . 302.3.4 Policy recommendations . . . . . . . . . . . . . . . . . . . . . . . 34 2.4 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 3 External and Internal Drain for a Countrys Banking System under Imperfect Information 41 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3.1.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 v 3.1.2 Relation to the literature . . . . . . . . . . . . . . . . . . . .