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Sources of Financial Fragility: the Role of Debt Management Sources of Financial Fragility: The Role of Debt Management Thesis submitted in accordance with the requirements for the degree of D o c t o r o f P h il o s o p h y by Elisabetta Falcetti Supervisor: Vassilis Hajivassiliou The London School of Economics and Political Science University of London United Kingdom April 2004 UMI Number: U185800 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI U185800 Published by ProQuest LLC 2014. Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code. ProQuest LLC 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 TH£S£S f V 710-1 ACKNOWLEDGMENTS I would like to thank everyone —academics, colleagues and friends— who has influenced this work and persuaded me to finish it. To begin with, I am grateful to my professors at Bocconi University in Milan who encouraged me to undertake my post-graduate studies abroad, first at DELTA (Paris) and then at the London School of Economics. The year in Paris has been highly instructive, not only from a scientific point of view but also a personal one. I would like to thank in particular Prof. Frangois Bourguignon and Prof. Richard Portes for their precious advice and supervision. The students resident at the Fondation Suisse made my staying there a very enriching and unique experience. The Centre for Economic Performance at the London School of Economics has been my second ‘home’ in London from 1997 to 2000. I am extremely grateful to my advisors Prof. Willem H. Buiter and Dr. Vassilis Hajivassiliou for their advice and guidance throughout this thesis. I am also highly indebted to Prof. Alessandro Missale who converted me to the study of debt management and taught me that research requires absolute dedication and sacrifice. A big thank you is due to Marco Polenghi and Maria Luisa Mancusi, with whom I shared the ups and downs typical of the life of Ph.D. students. With Maria Luisa I also shared the destiny and frustrations of having to finish a thesis while yet working. Thanks to her regular ‘cazziatoni ’ I found the strength to persevere. I would also like to thank my boss and work colleagues at the Office of the Chief Economist of the EBRD who encouraged and enabled me to take study-leaves to finalise this work. Finally, I would like to thank my relatives and friends for their unconditional support during all these years. Financial support from the Bank of Italy and the European Commission, TMR Fellowship # 972634 is gratefully acknowledged. ABSTRACT The main aim of this thesis is to investigate from both a theoretical and empirical point of view how debt management may affect the choice of the monetary and exchange rate regimes and ultimately influence the stability of financial systems. The thesis is organised as follows. In Chapter 1, we develop a simple theoretical model to analyse how the choice of the maturity and denomination of public debt instruments affects the choice of the optimal monetary target. We then compare debt management to alternative institutional mechanism designs and find that delegation of monetary policy to an independent central banker is a better solu­ tion to inflationary temptations than the issuance of foreign or indexed debt. Chapter 2 extends the analysis and shows that foreign currency debt may re­ duce the probability of a collapse of a fixed exchange rate regime. However, conditional on a currency crisis, countries with larger shares of foreign currency debt tend to experience sharper devaluations. Econometric results referring to the countries adhering to the Exchange Rate Mechanism of the European Mon­ etary System from 1979 to 1995 confirm these theoretical findings. In the second part of the thesis we look at the sources of financial vulnerability in a sample of emerging and developing countries from 1970 to 1997. In Chapter 3, we test the role of debt and exchange rate fragility in determining episodes of banking crises, while Chapter 4 extends the analysis of the causal link between currency and banking crises to episodes of twin crises. The results indicate that along with the increasing liberalisation and globalisation of the financial markets, banking and currency crises have become closely intertwined and driven by com­ mon fundamentals. Finally, Chapter 5 contains a description of the econometric specifications and simulation-based estimation techniques adopted in the second part of the thesis. DECLARATION 1. No part of this work has been presented to any University for any degree. 2. Chapter I, “The currency denomination of public debt and the choice of the monetary regime”, was conducted as a joint work with Prof. Alessandro Missale when he was Houblon-Norman Fellow at the Bank of England (October, 1997- May 1998). My contribution in this paper was 50%. A statement from my co-author confirming this is given below. 3. Chapter IV, “What do Twins Share?. A Joint Probit Estimation of Banking and Currency Crises” was undertaken as a joint work with Maria Mercedes Tudela. My contribution to this paper was 50%. A statement from my co­ author confirming this is given below. • I confirm the above declaration (point 2) referring to joint work carried out with Elisabetta Falcetti. Prof. Alessandro Missale • I confirm the above declaration (point 3) referring to joint work carried out with Elisabetta Falcetti. Maria M. Tudela CONTENTS Introduction .................................................................................................................. 10 1. Debt Management, Central Bank Independence and the Credibility of Monetary P o lic y ..................................................... 18 1.1 Introduction ................................................................................................. 18 1.2 The Theoretical Fram ework .................................................................... 20 1.2.1 The Government P ro b lem ......................................................... 20 1.2.2 A Dependent Central Bank ...................................................... 24 1.3 The Social Loss Function: A M o tiv a tio n .......................................... 26 1.4 An Independent Central B a n k ............................................................... 30 1.4.1 A Weight-Conservative Central Banker .................................. 30 1.4.2 An Inflation C o n tra ct ................................................................ 34 1.4.3 Inflation Targeting ....................................................................... 37 1.5 Independence and Debt Structure: The E vid en ce ........................... 38 1.6 Conclusions .................................................................................................. 53 2. Debt Management and the Sustainability of Fixed Exchange Rate Regimes 54 2.1 Introduction ................................................................................................ 54 2.2 Debt Management and Self-Fulfilling Confidence Crises: A Partial Review of the Literature ...................................................... 56 2.3 Exchange Rate Pegging ............................................................................. 61 2.4 The Exchange Rate Mechanism of the E M S ..................................... 68 2.5 The D ata .................................................................................................... 73 2.6 Estimation Methods and Results ......................................................... 75 Contents 6 2.7 Conclusions ................................................................................................ 91 Appendix A .......................................................................................................... 93 3. Banking Crises in Developing and Emerging M arkets.............................. 94 3.1 Introduction ................................................................................................ 94 3.2 Review of the Empirical L iteratu re ..................................................... 96 3.2.1 Leading Indicators A nalysis ...................................................... 97 3.2.2 Multivariate Analysis .................................................................... 99 3.3 This Study........................................................................................................102 3.4 The D a t a .......................................................................................................104 3.4.1 The Dependent Variable ................................................................. 105 3.4.2 Explanatory Variables .....................................................................110 3.5 The Empirical Methodology ......................................................................118 3.6 Estimation Results ...................................................................................... 120 3.6.1 The Baseline Specification ..............................................................122 3.6.2 Controlling for Exchange and Financial Liberalisation . 126 3.6.3 The Impact of Debt Variables ....................................................... 130 3.6.4 Leading Currency C rises
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