Essays in international finance

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 emerging markets.

(cont.) 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 Performance 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.