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Essays in International Finance by Geraint Paul Jones B.A Mathematics, University of Cambridge, 1995; Certificate of Advanced Studies in Mathematics, University of Cambridge, 1996; M.A. Mathematics, University of Cambridge, 1997; M.Sc. Econometrics and Mathematical Economics, London School of Economics and Political Science, 1999. Submitted to the Department of Economics in partial fulfillment of the requirements for the degree of Doctor of Philosophy MASSACHUSETTS INSTrTUTE at the OF TECHNOLOGY- MASSACHUSETTS INSTITUTE OF TECHNOLOGY JUN 0 6 2005 June 2005 LIBRARIES ( Geraint Paul Jones. All rights reserved. The author hereby grants to MassachusettsInstitute of Technologypermission to reproduce and to distribute copies of this thesis document in whole or in part. Signature of Author...... ; . .. .. .. .. · . .. ... /f...-pie nt of Economics /......... .. v/ April15th2Q5 Certifiedby................................. ....... / ....... ..' /' Ricardo Caballero Ford nternational Professor of Economics Thesis Supervisor Certifiedby................................. I - - . /' IV Xavier Gabaix Rudi Dornbusch Career Development Assistant Professor "I -_ Thesis Supervisor Accepted by .................................................... Peter Temin Elisha Gray II Professor of Economics Chairman, Departmental Committee on Graduate Studies !Mwiveiav Essays in International Finance by Geraint Paul Jones I Submitted to the Department of Economics on April 15th 2005, in partial fulfillment of the requirements for the degree of Doctor of Philosophy Abstract This thesis is a collection of three essays on exchange rate policies and international capital flows in emerging markets. The first chapter examines the theoretical foundations of the "fear of floating" that has been observed to characterize many emerging market exchange rate regimes. Building on a model that derives "fear of floating" from a desire to prevent non-fundamental shocks in foreign exchange markets affecting the real economy, the chapter shows that floating exchange rates can still be optimal in such an environment. It further argues that floating exchange rates should become more prevalent as emerging markets integrate more fully into the world economy. The second chapter investigates the empirical evidence on "fear of floating" with a view to determining whether the phenomenon is the optimal response of emerging markets to a volatile external environment, as supposed in the first chapter, or whether more emerging markets would optimally employ floating exchange rates. The chapter finds evidence that "fear of floating" has a dual aspect; that it might indeed be optimal during less severe external volatility, but during severe external shocks, fear of floating can lead to underinsurance against sudden stops in capital inflows. Such "fear of floating" is associated with a lack of credibility in monetary policymaking and the chapter argues that the evidence suggests that a credible commitment to floating exchange rates during severe external shocks would help insure emerging markets against sudden stops. The third chapter evaluates the link between foreign investment and corruption in emerg- ing markets. A model is developed of the link between FDI and corruption and the model is evaluated with data from the World Bank's Business Environment and Enterprise Perfor- mance Survey. It is found that corruption reduces aggregate FDI flows, but also distorts the composition of FDI towards firms more willing to engage in certain forms of corruption. FDI does not necessarily import better standards of governance. The chapter concludes with policy recommendation -for addressing the corruption in emerging markets. Thesis Supervisor: Ricardo Caballero Title: Ford International Professor of Economics Thesis Supervisor: Xavier Gabaix Title: Rudi Dornbusch Career Development Assistant Professor 2 Acknowledgements In the course of writing a dissertation, one inevitably accumulates numerous debts. I am extremely grateful to the faculty of the Department of Economics, MIT, and of course my two supervisors, Ricardo Caballero and Xavier Gabaix. Their support, guidance and wisdom improved this thesis immeasurably. I particularly thank Ricardo for giving me the opportunity to write the paper that became the second chapter for the Central Bank of Chile, and for introducing me to Francisco Gallego, with whom the paper was written, and firom whom I learned a lot. The third chapter was written jointly with Joel Hellman and Daniel Kaufmann of the World Bank, both of whom I thank not only for the experience of working together, but for encouraging me to undertake my graduate studies in the first place. My classmates at MIT have been a constant source of inspiration and I thank in particular Karna Basu, Matilde Bombardini, Thomas Chaney, Ivin FernAndez-Val, Ashley Lester, Daniel Paravisini, Nancy Qian, Ver6nica Rappoport and Ruben Segura-Cayuela. I thank my family for their unconditional support and encouragement, the foundation on which everything rests. Last but not least I thank my wife Valeria, who has accompanied me with love and patience through the highs and lows of graduate school, and whose constant support makes everything possible. Contents I Introduction 8 II Essays 12 1 Prevention or Cure? Exchange Rate Regimes and Noise Traders 13 1.1 Introduction . .. .. .. .. .. 13 1.2 An Exchange Rate Model with Noise Traders ........ 18 1.2.1 Macroeconomic Ingredients ............. 19 1.2.2 Endogenous Noise- The "Microstructure Channel" . 23 1.2.3 Equilibrium ...................... .. .. .. 25 .... 1.3 Objectives and Regimes ................... .. .. 27 ... 1.3.1 Government Objectives ................ .. 27 .... 1.4 The Optimal Exchange Rate Regime ............. .. ... 29 .... 1.4.1 Floating Exchange Rate Benchmark ......... .. .. 29 .... 1.4.2 Regimes with Commitment .............. .. .. 31 .... 1.4.3 When is a Commitment to Exchange Rate Volatility Optimal? ..... 35 1.4.4 "Almost Floating" Exchange Rates .......... .. 41 ... 1.4.5 Comparative Statics .................. .. .. 43 .... 1.5 Conclusions ........................... 45 1.6 Appendix ............................ 47 1.6.1 Appendix A: Equilibrium with a large trader .... 48 5 1.6.2 Appendix B: Derivation of the entry equation (1.16) ........... 50 1.6.3 Appendix C: Derivation of the Optimal Policies . 52 1.6.4 Appendix D: Proof of Proposition 1.5 .................... 59 1.6.5 Appendix E: Proof of Proposition 1.6 . 63 1.6.6 Appendix F: Proof of Proposition 1.7 ................... 67 1.6.7 Appendix G - Empirical Evidence ..................... 69 1.7 Bibliography ....................... 69 2 Exchange Rate Interventions and Insurance: Is "Fear of Floating" a Cause for Concern? 81 2.1 Introduction ...................................... 81 2.2 Fear of Floating: Theoretical Discussion ...................... 85 2.2.1 Existing Literature .............................. 85 2.2.2 A M odel . 88 2.2.3 Comparing the policy regimes ........................ 94 2.3 "Fear of Floating", Non-Contingent Floating and State-Contingent Flexibility . 95 2.3.1 M ethodology . 95 2.3.2 Data . ..................................... 100 2.3.3 The Stylized Facts .............................. 101 2.4 Exchange Rate Flexibility Index: Time Series Analysis . ........... 104 2.5 The Benefits of a Commitment to Floating ............... 107 2.6 Determinants of State Contingent Regimes ............. 111 2.7 Conclusions ........................ 113 2.8 Bibliography ..................................... 115 3 Far From Home: Do Foreign Investors Import Higher Standards of Gover- nance in the Transition Economies? 133 3.1 Introduction ...................................... 133 3.2 Data and Concepts .................................. 136 3.2.1 Unbundling and measuring corruption in the transition economies . 137 3.3 A Model of FDI and Corruption . ........................ 138 6 3.3.1 Basic Model .............................. 139 ... 3.3.2 Endogenous S and E and link with corruption .......... .. 140 ... 3.3.3 Provision of infrastructure S and public procurement corruption . 141 ... 3.3.4 Determination3.3.4-Determination of permitted externalities E and state capture..capture . .. 141 ... 3.3.5 Equilibrium with exogenouspolitical structure . 146 ... 3.3.6 Equilibrium with endogenouspolitical structure . .. 149 ... 3.3.7 Extensions ....................... 151 .... 3.3.8 Welfare and Policy measures ............. .. 152 .... 3.4 FDI Flows to the Transition Economies ........... .. 153 .... 3.5 Corruption by FDI Firms ................... .. 155 .... 3.6 Corruption and the Characteristics of FDI Firms ...... .. .. .. 158 ... 3.7 Does Regulation Control the Conduct of Foreign Investors? . .. 160 ... 3.8 Conclusion ........................... .. .. 163 .... 3.9 Bibliography ...................................... 164 3.10 Appendix A - Measuring Forms of Corruption and Classifying Countries .... 166 3.11 Appendix B - The BEEPS Data by the Legislative Status of the Source Country 168 7 Introduction The three chapters of this dissertation address issues related to exchange rate policies and international capital flows in emerging markets. The first chapter addresses the theoretical foundations of the "fear of floating" which has been observed to characterize many emerging market exchange rate regimes. The literature has identified circumstances under which optimal monetary policy limits exchange rate volatility. One argument proposed is that there exists a "microstructure channel" through which