CAPITAL FLOWS, INSTITUTIONS, AND FINANCIAL FRAGILITY

Transcription

1 CAITAL FLOWS, INSTITUTIONS, AND FINANCIAL FRAGILITY Wipawin romboon A disseraion submied o he faculy of he Universiy of Norh Carolina a Chapel Hill in parial fulfillmen of he requiremens for he degree of Docor of hilosophy in he Kenan-Flagler Business School (Finance). Chapel Hill 2009 Approved by: Advisor: Gregory W. Brown Reader: Jennifer Conrad Reader: Rober Connolly Reader: Chrisian Lundblad Reader: Larry Chavis

2 2009 Wipawin romboon ALL RIGHTS RESERVED ii

3 ABSTRACT WIAWIN ROMBOON: Capial Flows, Insiuions, and Financial Fragiliy (Under he direcion of Gregory W. Brown) This disseraion sudies he mechanism hrough which inernaional capial flows are ransmied from he banking secor o he real secor in a bank-based open economy when moral hazard problems are presen. I also examines he role of he qualiy of insiuions and domesic policies in reducing moral hazard problems and in deermining he ne benefi of inernaional capial flows o a counry. A general equilibrium model, incorporaing moral hazard problems a he bank, corporae and inernaional levels, is developed o explain his mechanism. In his unifying model, he hree layers of moral hazard problems and inernaional capial flows reinforce one anoher o amplify he boom-bus cycle of an economy, as seen in several crisis counries. The model predics ha an economy will never reach a seady sae when banks can accumulae losses and finance hose losses hrough foreign borrowing. This predicion underlines he role of inernaional capial flows and he moral hazard problems a he bank and inernaional levels in desabilizing an economy. The resuls from he parameer esimaion and he hypohesis esing using Thailand daa sugges ha here have been srucural changes in he qualiy of insiuions and domesic policies afer he Asian financial crisis and hese changes help alleviae he moral hazard problems a all levels in Thailand. Based on he simulaion exercises, he improvemen in banking supervision and foreign invesors risk esimaion helps subsanially reduce he bailou coss and he oupu losses during he recession. In conras, he reducion in governmen subsidies or ax incenives hurs, raher han helps, he economy since he cos from he overall oupu decline ouweighs he benefi from he lower bailou coss. iii

4 ACKNOWLEDGEMENTS I am graeful o my advisor, Gregory W. Brown, for his valuable guidance, suppor, and encouragemen. I would also like o hank my commiee members, Jennifer Conrad, Chrisian Lundblad, Rober Connolly, and Larry Chavis, for heir inspiraions and suggesions. I owe very special hanks o Sanley W. Black and Eric Ghysels for heir useful advice. Helpful commens and suggesions from ab Joikashira, Anusha Chari, Sergiy eredriy, Bumjean Sohn, and Jason C. Jones are much appreciaed. Finally, I would like o hank my parens, brohers, and friends for heir encouragemen and suppor. iv

5 TABLE OF CONTENTS LIST OF TABLES...vii LIST OF FIGURES....viii Chaper I. INTRODUCTION.. II. III. IV. LITERATURE REVIEW EMIRICAL EVIDENCE SUORTING THE KEY MODEL ASSUMTIONS..2 MODEL Srucure of he Model Sudden Sop Financial Crisis Analysis of he Model...34 V. ALICATION OF THE MODEL arameers of Ineres Hypoheses Thailand...44 VI. DATA.49 VII. METHODOLOGY Model Modificaions Calibraion and Esimaion GMM and Hypohesis Tesing Mehodology...57 v

6 VIII. EMIRICAL RESULTS Main Resuls Sensiiviy and Sabiliy Analysis IX. SIMULATION Coss and Benefis of Inernaional Capial Flows Conjecures abou he Resuls Scenarios Assumpions Simulaion Resuls Sensiiviy Analysis..78 X. MISSING COMONENTS OF THE MODEL AND AREAS FOR FUTURE RESEARCH.88 XI. CONCLUSION..9 AENDIX A: Equilibrium Condiions...94 AENDIX B: arameers and Variables...98 AENDIX C: Seady Sae Soluions AENDIX D: Linear Approximaions and Soluions for Linearized Difference Equaions...03 AENDIX E: Equilibrium Condiions in he Form of Firs Difference Equaions..07 AENDIX F: Descripions and Daa Sources of Variables Used as Insrumens AENDIX G: Seps o Calculae arial-sample GMM Esimaors and Wald Saisics 0 REFERENCES...30 vi

7 LIST OF TABLES Table. Descripions and Daa Sources of Variables Summary Saisics for he Whole Sample eriod Summary Saisics for Each Sub-eriod reliminary Correlaion Analysis Correlaions beween Seleced Macroeconomic Variables and Relevan Ineres Raes Exogenously-Deermined arameers arameer Esimaes from arial-sample GMM Esimaion Wald Saisics for Srucural Break Tess Simulaion Scenarios Direc and Indirec Coss in Comparison wih he Acual Daa Direc, Indirec, and Toal Coss Relaive o he Base Scenario vii

8 LIST OF FIGURES Figure. Time-Series aerns of Variables viii

9 CHATER I INTRODUCTION Recen globalizaion of economic aciviy and financial markes riggered financial liberalizaion in many counries, exposing hem o increasing volume of, and higher uncerainy from, inernaional capial flows. This fundamenally alered hisoric relaionships beween inernaional ransacions and aciviies of local financial inermediaries. While inernaional capial flows are an imporan source of capial for a counry s real invesmen, financial risks induced by large shor-erm inernaional capial flows, or so-called ho money, can poenially have an adverse effec on financial sysem sabiliy. Some anecdoal evidence suggess ha financial crises spill over o he real economy and in some cases resul in severe macroeconomic dislocaion. However, oher research insead suggess ha financial crises are he resul of fundamenal macroeconomic condiions. A dramaic example of his debae surrounds he financial crisis in Eas Asia during he lae 990s. A number of papers (e.g., Furman, Sigliz, Bosworh & Radele, 998; Radele, Sachs, Cooper & Bosworh, 998) highligh he major role of inernaional capial flows in deermining he financial insabiliy and resuling conagion. In conras, some research suggess ha he Asian crisis resuled principally from weak fundamenals due o regulaory inadequacy in he banking secor (Kaminsky & Reinhar, 999) and moral hazard problems induced by explici or implici guaranees from he local governmen or inernaional organizaions (Corsei, eseni & Roubini, 999a). These wo views, alhough differen, are no muually exclusive. As some prior research suggess (e.g., Henry & Lorenzen, 2003), i is no jus he quaniy of capial ha maers, bu also how he capial is uilized. In counries where moral hazard problems are severe, more available capial as a resul of financial liberalizaion may be uilized for bad invesmens or risky projecs. In

10 addiion, regulaory and insiuional capaciy o deal wih such moral hazard problems may no be able o keep pace wih rapid changes in financial markes. The recen subprime morgage crisis in he U.S. (wih major adverse consequences for banks and financial markes around he world) and he Asian financial crisis during he lae 990s highligh he role of inernaional capial flows via he banking secor and moral hazard problems in deermining macroeconomic sabiliy of an open economy. From a policy perspecive, more available foreign capial poses a significan risk for a counry which liberalizes financial markes oo quickly or oo broadly wihou adequae preparaion in erms of regulaions and insiuions (Sigliz, 999, 2002; Rodrik, 998). To he conrary, excessively slow financial marke liberalizaion could lead o low and inefficien invesmen, subopimal risk-sharing (exacerbaed home-bias), and relaively slow economic growh as implied by Bekaer, Harvey and Lundblad (2005). All hese debaes moivae wo imporan research quesions: () Wha is he ne effec of inernaional capial flows on a counry? (2) Are insiuions as imporan as suggesed by oher research or are hey a proxy for oher facors? Given he clear imporance of hese issues, a number of researchers have sudied he deerminans as well as he coss and benefis of inernaional capial flows o a counry. Many of hem focused only on he coss (e.g., Huchison & Noy, 2006; Boyer, Kumagai, & Yuan, 2006) or he benefis of financial liberalizaion (e.g., Bekaer e al., 2005; Henry, 2000a, 2000b). Also, he empirical resuls regarding he benefis of capial flows are mixed. Hence, he issue of wheher inernaional capial flows are ruly desabilizing remains unresolved. In addiion, mos of hose sudies are cross-counry. Thus, hey canno accoun for all ypes of heerogeneiies across counries nor can hey analyze he facors driving he coss and benefis of inernaional capial flows, such as he qualiy of insiuions, for each counry in deail. The issue of wheher he qualiy of insiuions maers herefore has no been horoughly explored a he deailed counry level. Looking a an 2

11 economy ha has made insiuional changes and esimaing he impac is a way o invesigae boh if insiuions really maer, and if so, how much. This disseraion aims o () sudy he ransmission mechanism of inernaional capial flows via he banking secor o he real secor of an open economy when moral hazard problems are presen in a unified srucural framework and (2) examine he role of he qualiy of insiuions and domesic policies in reducing moral hazard problems and deermining he ne benefi of inernaional capial flows o a counry in he long run. The focus of his paper is primarily on small open economies for he following reasons. Firs, hose counries experienced an influx of inernaional capial flows afer heir financial liberalizaions and many wen hrough financial crises wih sudden reversals of capial flows. Hence, hey are good subjecs for examining boh he coss and benefis of inernaional capial flows. Second, several of hem, especially hose ha experienced crises, have undergone major reforms and significan changes in he qualiy of insiuions and domesic policies afer he crises. Such reforms can hen be used o examine he effecs of changes in he qualiy of insiuions and domesic policies on hose counries. To address he firs objecive, a heoreical model under he general equilibrium framework is developed o explain he ineracions beween inernaional capial flows and each secor of a small open economy during boh non-crisis and crisis periods when moral hazard problems are presen. This model incorporaes several imporan faces of he real and financial economy, allowing shocks o he banking secor o be ransmied o he real secor, and vice versa, via he ineres rae mechanism. I also addresses several aspecs of moral hazard problems, raher han focusing on only one of hem as many oher moral hazard models have done (e.g., Corsei, eseni, & Roubini, 999b; Dekle & Klezer, 2005). The unifying propery of his model allows ineracions beween differen aspecs of moral hazard problems as hey could be reinforcing or offseing one anoher. This propery also makes he model more consisen wih wha has been observed, as here exis muliple ypes of moral hazard problems, alhough in differen degrees, in mos counries. Hence, compared 3

12 wih oher moral hazard models, his model is more versaile and so is applicable o a broader se of counries. The main assumpions of he model are based on key observaions of counries experiencing crises over he pas wo decades. Firs, an economy is largely relian on he banking secor, which has access o large sources of inernaional funds. Second, due o poor qualiy insiuions and domesic policies, here are hree layers of moral hazard problems in he counry before a crisis (i.e., moral hazard problems a he corporae, bank, and inernaional levels). Third, a sudden sop of inernaional capial flows is riggered when he expeced level of coningen governmen liabiliies (he amoun of banks cumulaive losses) exceeds he level of he counry s inernaional reserves. In his model, he hree layers of moral hazard problems, ogeher wih inernaional capial flows, reinforce one anoher o amplify he boom-bus cycle of he economy. Firs, a he corporae level, expeced governmen subsidies or ax incenives increase firms expeced profis, inducing firms o inves more and borrow more from banks han hey should wihou he governmen subsidies or ax incenives. In he model, a firm s opimal level of capial sock is increasing wih he level of governmen subsidies or ax incenives. Second, a he bank level, when a fuure governmen bailou is expeced and banking supervision is inadequae, banks are willing o lend excessively o he corporae secor as long as hey can obain enough funding from deposiors (he household secor) and foreign crediors. In addiion, banks have an incenive o pay ou heir profis from performing loans as dividends o heir shareholders, raher han mainaining such profis as provisions agains heir losses from nonperforming loans (NLs). Hence, NL losses are accumulaed on he banks accouns, and banks have o finance hose losses hrough addiional foreign borrowing. In his model, he level of NL losses ha banks can accumulae in each period is deermined by heir loan loss provisioning raio. As menioned in Corsei e al. (999a), he role of moral hazard a he onse of he Asian crisis has been sressed by a number of auhors, e.g., Krugman (998a), Greenspan (998), and Fischer (998b). 4

13 Third, a he inernaional level, wih a presumpion ha governmen guaranees exis and he governmen is commied o a sable exchange rae, foreign crediors are willing o lend excessively o he domesic banking secor as long as he expeced level of he governmen s coningen liabiliies is below he level of he counry s inernaional reserves. They also underesimae he risks from heir lending o he domesic banking secor and do no charge ineres raes high enough o compensae for heir risks, because hey believe ha he governmen will bail ou hose banks if hings go wrong. In addiion, hey do no expec exchange raes o be responsive o changes in ineres rae differenials since hey believe ha he governmen will aemp o mainain a sable exchange rae. In his model, foreign invesors percepions of risks and heir expecaions of exchange rae movemens are refleced in he deerminaion of a domesic ineres rae and an exchange rae. aricularly, he banks cos of foreign borrowing is modeled o be increasing wih he aggregae level of banks ne foreign borrowing. Alhough exending more credi o he banking secor in anoher counry exposes foreign invesors o higher risks, hey may no fully ake ino accoun hose risks when deermining he rae of reurn if hey believe ha governmen guaranees exis. The sensiiviy of he banks foreign borrowing rae o he aggregae level of banks ne foreign borrowing hus reflecs he level of risks ha foreign invesors perceive and facor ino heir required rae of reurn. The higher his sensiiviy, he more expensive i is for banks o increase heir foreign borrowing. The exchange rae in his model is deermined by an ineres rae differenial and an expeced exchange rae deviaion from he uncovered ineres rae pariy (UI) relaion according o a modified UI. When he expeced exchange rae deviaion from he UI is equal o zero, he exchange rae is solely deermined by he ineres rae differenial and is no influenced by he governmen. Alhough moral hazard problems a all levels play a role in magnifying he boom-bus cycle of an economy, he analysis of he model suggess ha he moral hazard problems a he bank and inernaional levels are primarily he facors causing an economy o move away from is equilibrium and riggering a sudden sop and a crisis. When banks can accumulae NL losses (he moral hazard 5

14 problem a he bank level) and can obain addiional foreign borrowing o finance hose losses (he moral hazard problem a he inernaional level), he economy will never be a a seady sae, as NL losses and foreign deb coninue o increase. Once he level of banks cumulaive NL losses exceeds he level of he counry s inernaional reserves, a sudden sop will surely occur. To address he second objecive, he model parameers measuring he severiy of moral hazard problems are used as proxies for he qualiy of insiuions and domesic policies. A crisis counry ypically has gone hrough major insiuional reforms afer a crisis. Hence, is qualiy of insiuions and domesic policies may be significanly changed, and is moral hazard problems may have been reduced. If his hypohesis is rue, he parameers measuring moral hazard problems should indicae a lower degree of moral hazard problems afer a crisis. In addiion, since he moral hazard problems, ogeher wih inernaional capial flows, amplify he boom-bus cycle of an economy, he lower degree of moral hazard problems may resul in lower cos or higher benefi of inernaional capial flows o a counry. To examine he above hypoheses, he parameers deermining moral hazard problems a all levels are esimaed for pre-crisis, crisis, and pos-crisis periods using he equilibrium condiions from he model and he generalized mehod of momens (GMM) approach o fi he daa of a small open economy which has experienced a crisis. The chosen counry is Thailand since i exhibis characerisics consisen wih he key assumpions of he model. I is also no an exreme example, considering is rankings among all oher emerging counries in erms of is degree of openness, economic performance, and qualiy of insiuions. The hypohesis ess for he differences in parameer values before and afer he crisis are conduced o examine if here have been significan changes in he qualiy of insiuions and domesic policies leading o a lower degree of moral hazard problems afer he crisis. Simulaion exercises are also underaken o assess he impac of changes in he qualiy of insiuions and domesic policies on he ne benefi of inernaional capial flows. Boh direc coss (bailou coss) and indirec coss (oupu losses) of a crisis wih a sudden sop of capial 6

15 flows are esimaed using he simulaed daa under differen moral hazard scenarios. The resuls from he hypohesis esing and he simulaion exercises sugges ha he moral hazard problems a all levels are less severe afer he crisis and he changes in he qualiy of insiuions and domesic policies wih regard o banking supervision and foreign invesors percepions of risks help significanly reduce he bailou coss and he oupu losses. In conras, he reducion in he governmen subsidies or ax incenives o he corporae secor hurs, raher han benefis, he counry, as he cos from he lower oupu ouweighs he benefi from he lower bailou coss. The res of his disseraion is organized as follows. Chaper II discusses he relaed lieraure. Chaper III presens he empirical evidence supporing he key assumpions of he model. Chaper IV develops he heoreical model. Chaper V discusses he applicaion of he model. Chaper VI describes he daa and summary saisics. The mehodology and esimaion resuls are explained in Chaper VII and Chaper VIII, respecively. Chaper IX presens he simulaion resuls. Chaper X discusses missing componens of he model and areas for fuure research. Chaper XI concludes. 7

16 CHATER II LITERATURE REVIEW The relaionships beween inernaional capial flows and macroeconomic condiions have been widely sudied in he inernaional economics lieraure. Early lieraure examined he relaionships beween capial flows and he saving-invesmen gap. Fleming-Mundell and Obsfeld- Rogoff models provide basic heoreical frameworks for analyzing such relaionships. Kraay and Venura (2000, 2002) and Venura (2003) incorporae invesmen risk ino consumers porfolio composiion decisions, which hus deermine he domesic capial sock and he ne foreign asse posiion of a counry. Moivaed by concerns over financial insabiliy caused by inernaional capial flows, a number of researchers examine he mechanisms hrough which inernaional capial flows creae sudden sops and crises (e.g., Calvo, 998; Rodrik & Velasco, 999). Chari and Kehoe (2003) develop a model of herd behavior where informaional fricions ogeher wih weak fundamenals lead o volaile capial flows (resembling ho money) and in urn cause a financial crisis. Inspired by he marke microsrucure lieraure on he relaionships beween foreign exchange (FX) order flows and FX raes, 2 more recen works examine he wo-way causal relaionships beween inernaional capial flows and macroeconomic as well as financial marke indicaors. Hau and Rey (2006) develop a model in which exchange raes, sock prices, and capial flows are joinly deermined under incomplee foreign exchange risk rading. Empirical work in his line of research includes Hau and Rey (2004), Siourounis (2003), Froo, O Connell, and Seasholes (200), Froo and Ramadorai (200, 2005) and owell, Raha, and Mohapara (2002). Similar o his lieraure, his disseraion 2 Viale (2007) surveys he marke microsrucure approach o exchange rae deerminaion.

17 emphasizes he role of he banking secor and moral hazard problems in deermining he ne benefi of inernaional capial flows o a counry. This disseraion is also relaed o he lieraure on currency and financial crises. 3 The firs generaion of crisis models was pioneered by Krugman (979). In his ype of model, unsusainable fiscal policy causes he collapse of a fixed exchange rae regime and a crisis. The second generaion of crisis models was iniiaed by Obsfeld (986). In hese models, doubs abou he governmen abiliy o mainain is fixed exchange rae bring abou muliple equilibria, and speculaive aacks occur as a resul of self-fulfilling expecaions, no because of irresponsible policies. The hird generaion of crisis models examines he role of he banking secor in iniiaing or amplifying he severiy of a crisis (e.g., Disyaa, 2004; Zhou, 2008). The hree main versions of he hird generaion models as suggesed by Krugman (200) are bank run, balance-shee effec and moral hazard models. In he bank run models (e.g., Chang & Velasco, 2000, 200), he focus is on a bank s mauriy mismach, and a bank run occurs based on self-fulfilling expecaions ha he bank may no be able o pay deposiors who come o wihdraw heir money laer. In he balance-shee effec models (e.g., Burnside, Eichenbaum & Rebelo, 200a), banks and firms have an incenive o expose hemselves o greaer FX risk in he presence of governmen guaranees. The model presened in his paper is mosly relaed o a moral hazard sory. The basic feaure of moral hazard models (as seen in many papers, e.g., Dooley, 2000; McKinnon & ill, 996) is he role of expeced governmen guaranees in causing inernaional invesors o lend a large amoun of money o anoher counry, leading o excessive risk-aking behavior of agens in ha counry. Apar from he moral hazard problem a he inernaional level, here are many oher levels of moral hazard problems. Wih regard o he moral hazard problem a he corporae level, Corsei, eseni, and Roubini (999b) develop a model in which here are expecaions ha he governmen will provide financial suppor o firms if hey are in a bad sae. Such expecaions increase firms expeced profis 3 Burnside, Eichenbaum, and Rebelo (2008), Krugman (200), and Tinnakorn (2006) provide a review of crisis models. 9

18 and cause firms o overinves. Firms can easily ge funds from overly opimisic elie consumers, who have access o inernaional funds and expec a governmen bailou when firms are in a bad sae. Since firms do no receive ransfers from he governmen righ away, elie consumers have o finance heir losses or cash shorfalls hrough foreign borrowing. Once heir cumulaive losses exceed he level of he counry s inernaional reserves, a sudden sop of capial flows occurs. Wih regard o he moral hazard problem a he bank level, Dekle and Klezer (2005) develop a model in which banking supervision is inadequae and here is a widely held percepion ha governmen guaranees exis. Hence, banks have an incenive o pay dividends from heir performing loan profis, raher han mainain hem as provisions agains heir non-performing loan (NL) losses. Banks herefore accumulae NL losses, which laer become coningen governmen liabiliies. Once he level of banks cumulaive NL losses exceeds a cerain hreshold, he governmen inervenes, and banks can no longer accumulae losses. However, in heir model, banks receive funds only from domesic deposiors; hence, here is no role for inernaional capial flows. This disseraion addresses several aspecs of moral hazard problems, raher han focusing on only one of hem. aricularly, he model developed in his disseraion incorporaes () expeced governmen subsidies or ax incenives o he corporae secor which lead o overinvesmen, similar o wha we have seen in he paper by Corsei e al. (999b), 4 (2) lax banking supervision which leads o an accumulaion of banks NL losses, as seen in he paper by Dekle and Klezer (2005), and (3) expeced governmen guaranees and he governmen s commimen o a sable exchange rae which cause foreign invesors no only o lend a large amoun of money o domesic banks, bu also o underesimae heir risks associaed wih lending o banks in anoher counry. Hence, his model is more applicable o counries wih muliple moral hazard problems. In addiion, unlike many oher heoreical papers, model parameers are esimaed, raher han calibraed, in he empirical analysis. 4 In his model, expeced governmen subsidies or ax incenives o he corporae secor are modeled differenly. Unlike he model by Corsei e al. (999b), subsidies from he governmen o he corporae secor in his model are conemporaneously provided o all firms in each period, raher han provided only o low-ype firms and accumulaed as he governmen s expeced coningen liabiliies. 0

19 Regarding he coss and benefis of inernaional capial flows, a large number of researchers explore he fundamenal issue of wheher foreign capial flows are desabilizing or benefiing a counry or boh. Quinn (997) and Bekaer e al. (2005) find ha counries wih greaer openness o capial mobiliy experience higher growh han counries wih resricions on capial mobiliy while Rodrik (998) finds no such associaion. To he conrary, Huchison and Noy (2006) find ha sudden-sop crises--currency/balance of paymen crises wih reversals in capial flows--have a large negaive, bu shor-lived, impac on oupu growh (over ha found in oher crises wihou reversals in capial flows). Ineresingly, he benefis of financial liberalizaion migh no be as srong as expeced due o agency problems arising when rulers of sovereign saes and corporae insiders pursue heir own ineress a he expense of ouside invesors (Sulz, 2005) and inadequacy of laws and supporing insiuions (Henry & Lorenzen, 2003). However, his issue has no been horoughly explored a he deailed counry level. This disseraion adds o his line of research by furher examining he role of he qualiy of insiuions and domesic policies in reducing moral hazard problems and in deermining he ne benefi of inernaional capial flows o a counry. aricularly, he parameer values associaed wih he severiy of moral hazard problems are esimaed and used o assess he effec of changes in he qualiy of insiuions and domesic policies on he coss and benefis of inernaional capial flows in he simulaion exercises.

20 CHATER III EMIRICAL EVIDENCE SUORTING THE KEY MODEL ASSUMTIONS The main assumpions of he model developed in he nex chaper are based on key observaions of counries which have experienced financial crises. Over he pas couple decades, a number of crises have occurred around he world, e.g., Mexican eso crisis during , Asian financial crisis during , Russian financial crisis in 998, Argenine economic crisis during The mos recen global financial crisis resuled from he subprime morgage crisis in he U.S. and has had a large adverse impac on financial markes and economies around he world. For example, he Icelandic financial crisis has resuled in he collapse of all hree major banks in Iceland. Those crises share several similariies. Firs, inernaional capial flows played a key role in fueling a boom, and in many of hose counries he banking secor played an imporan role in channeling funds o he real secor. A he end of 997, bank loans accouned for 77% of he oal exernal finance for Thailand, 68% for Indonesia, 52% for he hilippines, and 65% for Souh Korea while in he U.S. bank loans represened only 23% of he oal exernal finance. 5 Also a large fracion of foreign borrowing was inermediaed by he domesic banking sysem. Based on Bank for Inernaional Selemens (BIS) daa on foreign liabiliies of domesic banks and non-banks owards BIS reporing banks, in mid 997, he raio of foreign borrowing inermediaed by he domesic banking secor was 77% for Malaysia and Korea, 69% for he hilippines, 86% for Thailand, and 78% for China (Corsei e al., 999a). 5 These raios are calculaed using he figures from Exper Group on he Challenges of he Asian Economy and Financial Markes (200), which are based on Inernaional Financial Saisics daa of he Inernaional Moneary Fund (IMF-IFS).

21 Second, here were ypically srucural and policy disorions before each crisis, which caused he privae secor (or he public secor in he case of Mexico, Russia and Argenina) of a crisis counry o excessively accumulae deb and hen rigger a financial crisis. aricularly here was a widely held percepion ha explici and/or implici governmen guaranees or subsidies for corporae and financial invesmen exised, causing firms o overinves, banks o lend excessively o risky borrowers, and foreign capial o flow ino a counry. Furhermore, several of he crisis counries adoped rigid exchange rae regimes, for example, pegged exchange raes in Thailand, Argenina, and Mexico and managed floa regimes in Korea, Indonesia, and Russia. Worsening he siuaion, banking supervision was ypically quie lax before a crisis. Hence, several banks, such as commercial banks in many Asian counries and Iceland as well as invesmen banks in he U.S., had an incenive o ake excessive risks o enhance reurns. Third, a sudden sop of capial flows and a run occurred when he expeced level of a counry s deb (eiher public or privae deb) was so high ha invesors did no believe ha he governmen would be able o fulfill is financial obligaions. In fac, here were several signs of a counry s vulnerabiliy o a crisis and a sudden reversal of capial flows in hose crisis counries. Many of hem had curren accoun imbalances before a crisis and hus were suscepible o a sudden reversal of capial flows, especially when such imbalances were financed by shor-erm flows or by insrumens indexed o oher currencies. For example, Thailand experienced a curren accoun defici for over a decade, and by 996 only 6% of is curren accoun defici was financed by foreign direc invesmen (FDI) (Corsei e al., 999a) while Mexico financed is curren accoun defici of 7% of GD by deb insrumen denominaed in pesos bu indexed o dollars. In addiion, here was a lending boom prior o a crisis. In counries experiencing he Asian financial crisis, he raio of privae secor lending o GD exhibied an increasing rend. The growh rae during of privae secor lending o GD raio was highes in he hilippines (5%), Thailand (58%), and Malaysia (3%) (Corsei e al., 999a). In he U.S., he home ownership rae increased from 64% in 3

22 994 o 69.2% in 2004, and subprime lending was a major conribuor o his increase. In several crisis counries, asse qualiy was in doub. The non-performing loans o oal loans raio in 996 was esimaed o be 3% for Thailand and Indonesia, 8% for Korea, 0% for Malaysia, and 4% for he hilippines (Corsei e al., 999a). Moreover, here was a serious mismach beween foreign liabiliies and foreign asses in many crisis counries. The raio of foreign liabiliies o foreign asses relaive o BIS reporing banks exceeded 00% in counries experiencing he Asian financial crisis during (Corsei e al., 999a). Based on he above key observaions, he model in Chaper IV is developed using he following assumpions: () he banking secor plays a key role in channeling inernaional capial flows o he corporae secor, (2) moral hazard problems a he corporae, bank, and inernaional levels are presen in an economy, and (3) a sudden sop of capial flows occurs when he expeced level of he counry s deb is greaer han he level of he counry s liquid asses. 4

23 CHATER IV MODEL This chaper presens a general equilibrium model of a bank-based, small open economy wih moral hazard problems. The focus of his model is primarily on small open economies since hose counries experienced an influx of inernaional capial flows afer heir financial liberalizaions and many of hem underwen financial crises wih sudden reversals of capial flows. Hence, hey are good subjecs for examining boh he coss and benefis of inernaional capial flows. Moreover, several of hem have gone hrough major insiuional reforms afer he crises. Such reforms can hen be used o examine he impacs of changes in he qualiy of insiuions and domesic policies on hose counries. Alhough he model in his chaper is developed for a small open economy, i can be exended for a large open economy by endogenizing he world ineres rae. This model is developed wih he aim of explaining he relaionship beween inernaional capial flows via he banking secor and he real economy, he occurrence of a financial crisis, and how moral hazard problems amplify he impac of inernaional capial flows on a counry. The model incorporaes several imporan aspecs of he real and financial economy, allowing shocks o one secor o be ransmied o he ohers hrough ineres raes. I also combines and exends he crisis models by Corsei e al. (999b) and Dekle and Klezer (2005) o simulaneously address he hree levels of moral hazard problems (i.e., he corporae, bank and inernaional levels), which are normally observed in a crisis counry. The unifying propery of his model allows ineracions beween differen levels of moral hazard problems as hey could be reinforcing or offseing one anoher.

24 Following he idea of Corsei e al. (999b), he moral hazard problem a he corporae level resuls from expeced governmen subsidies or ax incenives, which increase firms expeced profis and induce firms o overinves. There are differen ways o model his level of moral hazard problem. Firs, i can be assumed ha here is an anicipaion of a fuure corporae bailou only o firms ha are in a bad sae (low-ype firms) so ha hey can a leas break even and survive, as seen in he model by Corsei e al. (999b). Hence, he expeced number of non-performing companies is zero. In heir model, firms losses are also no conemporaneously offse by governmen ransfers. Therefore, elie consumers (fund providers of firms) have o cover heir losses and cash shorfalls hrough furher foreign borrowing. The expeced governmen ransfers o subsidize firms losses are hus accumulaed as he governmen s expeced coningen liabiliies. Second, i can be assumed ha here is an expecaion of governmen subsidies or ax incenives o all firms, bu ransfers are no conemporaneously made in each period. Thus, firms have o finance heir cash shorfalls, if any, hrough addiional bank borrowing or securiies issuance, and he expeced ransfers from he governmen o firms are accumulaed as he governmen s expeced liabiliies. Third, governmen subsidies or ax incenives can be assumed o be conemporaneously provided o firms in each period. Hence, here is no accumulaion of he expeced governmen ransfers o firms. In his model, governmen subsidies or ax incenives are conemporaneously provided o firms in each period according o he hird approach for he following reasons. Firs, in several counries, governmen subsidies or ax incenives are provided o firms on a period-by-period basis. Second, unlike Corsei e al. (999b), which focus on he moral hazard problem a he corporae level, he banking secor is explicily incorporaed, and is role as he main foreign borrower and major loan provider for he corporae secor is emphasized in his model. If he moral hazard problem a he corporae level is modeled according o he firs approach, banks non-performing loans (NLs) are expeced o be zero since he governmen will finally bail ou hose low-ype, unprofiable firms. In realiy, his is no he case as banks accumulaion of NL losses plays a key role in riggering and 6

25 aggravaing a crisis. Following he idea of Dekle and Klezer (2005), he moral hazard problem a he bank level is added. Tha is, given an expeced governmen bailou and inadequae bank monioring, banks have an incenive o accumulae losses from NLs. Besides, banks in his model can borrow from abroad, unlike hose in he model of Dekle and Klezer (2005). Hence, hey will finance heir losses or cash shorfalls hrough addiional foreign borrowing. In addiion, he moral hazard problems a he inernaional level are explicily modeled here hrough he deerminaion of an ineres rae for banks foreign borrowing and an exchange rae. resumpions by foreign invesors ha governmen guaranees for corporae and financial invesmen exis and ha he governmen is commied o a sable exchange rae causes hem o underesimae he risks associaed wih heir lending o he domesic banking secor. Foreign invesors herefore do no charge an ineres rae high enough o compensae for heir risks. Moreover, an exchange rae is expeced o deviae more from he convenional uncovered ineres rae pariy when a counry adops a pegged exchange rae regime since invesors anicipae ha he governmen will ry o mainain a consan exchange rae, regardless of he level of an ineres rae differenial. Furhermore, a sudden sop of capial flows and a financial crisis can occur in his model when he level of he counry s inernaional reserves (a proxy for liquid asses) is below he level of cumulaive losses in he banking secor (he expeced level of coningen governmen liabiliies) Srucure of he Model The model considers a bank-based, small open economy wih four major secors: () a corporae secor, (2) a banking secor, (3) a household secor, and (4) a public secor (governmen), which combines fiscal and moneary auhoriies. 6 Similar o Burnside, Eichenbaum, and Rebelo (2000, 200b), his emphasizes he role of prospecive governmen defici in causing a crisis. 7

26 4.. Corporae Secor There are N firms in each period. Each firm j is owned by households in a well-diversified porfolio and pays ou all is ne profis as dividends o is exising shareholders. Each firm j specializes in he producion of raded goods y and has he following producion funcion. y A k l = α α (F) Where y = Firm j s oupu for period, k = Firm j s physical capial a he end of period, A = roducion echnology facor for period, which is assumed o be random and subjec o firm ype, l = Firm j s employed labor a he end of period, α = Income share of capial (0 α ). A he beginning of period (a he end of period ), each firm j invess I J = k - k - d k - o produce raded goods y and o finance is capial depreciaion. The fracion (-cap) of is new invesmen (i.e., k -k - ) is financed hrough bank deb (0 cap ) while he remaining porion is financed hrough newly-issued preferred socks or bonds, which are sold o he household secor. Each firm j uses is own profis o finance capial depreciaion (d k - ), where d is he capial depreciaion rae and 0 d. Banks, new bondholders, and new shareholders demand he same rae of reurn of r l from a firm. I is assumed ha labor is inelasically supplied, and each firm j pays wages a a rae W per one uni of labor. There are 2 ypes of firms in each period. Ex ane each firm does no know is ype (A ). The fracion (-NL ) of he firms is high-ype wih producion echnology Au, and he remaining fracion NL is low-ype wih producion echnology A-w. Those low-ype firms are no able o pay ineres on deb. Assume ha (- NL )u (NL )w = 0, A > u > w > 0 and α α 0 NL. Hence, (A ) A and E [y ] Ak l. E = = 8

27 In addiion, firms may have o pay axes o he governmen. To promoe invesmen, he governmen may provide subsidies or ax incenives o firms. The expeced value of ne ransfers o/from he governmen is equal o E (s ) = nk l α α, where n could eiher be posiive (subsidies) or negaive (axes). Assuming ha firm j s expeced profis are based on is long-run average amoun of employed labor, a he beginning of period (a he end of period ), each firm j chooses he level of capial sock (k ) o maximize is expeced profis for period (π F ). π F = Expeced[Oupu Subsidies( Taxes) Wages Ineres paymens Capial depreciaion expenses] j l = E [ y s W l r k d k ] Ak l nk l W l ( NL ) r k d k α α α α l = (F2), subjec o I j = (k k ) d k (Toal invesmen = New invesmen Capial depreciaion) (F3), k j = e cap (Uses of capial = Sources of capial k = Bank deb Newly-issued bonds or socks) (F4), where j α α E [y ] = Ak l = Firm j s expeced oupu for period, j α α E [s ] = nk l = Firm j s expeced subsidies or axes for period, j E [W l] = W l = Firm j s expeced wages paid o is labor in period, E [r k ] = ( NL ) r k = Firm j s expeced ineres paymens for period, j l l E [d k ] = d k = Firm j s expeced capial depreciaion expenses in period, j k = Firm j s level of capial sock a he end of period, e j = (-cap) k = Firm j s bank deb a he end of period, 9

28 cap k = Firm j s cumulaive amoun of newly-issued bonds or socks a he end of period, W = Wage rae used for period, l = Long-run average amoun of employed labor, r l = Rae of reurn required by banks and new bond/shareholders for period, I j = Firm j s invesmen, A = Average producion echnology facor, n = Firm j s addiional revenue or cos facor due o governmen subsidies or axes, d = Capial depreciaion rae (0 d ), cap = Fracion of firm j s invesmen financed by capial markes, NL = Fracion of low-ype firms a he end of period. Based on he above seup, he opimal level of capial sock (by rearranging he firs order condiion wih respec o k ) of each firm equals k α α(a n) = l (F5). l ( NL )r d The opimal level of capial sock is increasing wih parameer n, which measures he level of governmen subsidies (or axes if negaive). The higher he level of governmen subsidies or ax incenives (or lower axes), he higher he firm s expeced profis and he greaer he incenive for he firm o overinves. Hence, parameer n can be used as a measure of he degree of overinvesmen or he moral hazard problem a he corporae level. However, since he oupu is increasing wih he level of capial sock ( y = A k l α α ), he higher degree of overinvesmen, as a resul of he higher level of governmen subsidies or ax incenives, also brings abou higher oupu. I can also be seen ha he opimal level of capial sock is decreasing wih he rae of reurn demanded by banks 20

29 and bond/shareholders (r l ). Hence, he ineres rae plays a key role in influencing he firm s invesmen decision in his model Banking Secor Suppose ha here are M idenical banks. Each bank i receives deposis (a i ) in local currency (LC) real erms from households and borrows (b i ) in foreign currency (FC) nominal erms from foreign crediors. I pays a real deposi rae of r o deposiors and a nominal foreign borrowing rae of i b o foreign crediors. i b i r The weighed average cos of funds for each bank (r c a i b ) =. i i a b Each bank i lends is money in LC real erms (e i ) o he corporae secor and charges a lending rae of r l. Only high-ype firms (he fracion -NL of he firms) can pay ineres on bank deb in each period. In addiion, each bank has operaing expenses of o,, which are assumed o be mainly employee salaries. Assume ha o = ξ e i, where ξ is he operaing expense facor and ξ 0. In his model, he bank s nominal foreign borrowing rae (i b ) is a funcion of he world nominal ineres rae and he aggregae level of banks ne foreign borrowing, i.e., i b ( b bˆ ) w = ψ i ψ (B), 0 w Where i = World nominal ineres rae for period, b = Aggregae level of banks ne foreign borrowing a he end of period, ψ 0 = Ineres rae sensiiviy o he world ineres rae, ψ = Ineres rae sensiiviy o he aggregae level of banks ne foreign borrowing, b ˆ = erceived opimal level of aggregae banks ne foreign borrowing. 2

30 The benefis of modeling he foreign borrowing rae his way are wofold. Firs, parameer ψ, which is expeced o be greaer han or equal o zero, reflecs how much higher he rae of reurn foreign crediors need o compensae for heir higher risks from a greaer amoun of lending o he banking secor in anoher counry. Hence, parameer ψ can be used as a measure of he degree of a moral hazard problem a he inernaional level. When his moral hazard problem is severe, foreign crediors underesimae he risks from heir lending o he banking secor and do no fully incorporae hose risks ino heir required rae of reurn, and hus he value of parameer ψ is low. As menioned earlier, his could happen when foreign crediors believe ha governmen guaranees exis. 7 There could be an exreme case in which foreign crediors srongly believe ha he governmen guaranees will cover he whole amoun of credi hey have graned o he banking secor in anoher counry. They herefore do no ake ino accoun he higher risks from he greaer amoun of heir lending o he banking secor in such a counry and demand he same low rae of reurn, regardless of he level of banks ne foreign borrowing. arameer ψ in his exreme case will be equal or close o zero. Second, his is one way o induce saionariy o a small open economy model according o Schmi- Grohe and Uribe (2003). aricularly, when ψ is greaer han zero, domesic ineres raes serve as an adjusmen and ransmission mechanism hrough which any shock affecing he level of banks ne foreign borrowing will have an impac on firms invesmen decision and households saving decision. Each bank i is owned by households in a well-diversified porfolio and may choose o pay dividends o is shareholders in each period. When banks are no adequaely moniored and when here is a widely held percepion ha governmen guaranees exis, i is opimal for banks o mainain minimal loan loss reserves and o pay ou heir profis from performing loans (Ls) (or high-ype 7 An alernaive sory as proposed by Giannei (2007) could be an informaion asymmery problem. In his model, foreign crediors do no know he qualiy of bank asses. Hence, hey iniially lend o banks a a low ineres rae. This enables insolven banks o accumulae bad loans. In equilibrium, when a subsanial amoun of losses have been accumulaed, solven banks do no find i any longer opimal o issue deb a he ineres raes ha would compensae invesors for risks. Foreign invesors anicipae his and sop lending o banks. 22

31 firms) as dividends (X i ) o heir shareholders. This creaes anoher layer of moral hazard a he bank level. Assume ha each bank mainains he fracion υ (0 υ ) of is profis from Ls as provisions agains is losses from non-performing loans (NLs). Dividends paid by each bank i are hus equal o he fracion (-υ) of is profis from Ls, i.e., X i = ( - υ) (rofis from Ls) = ( - υ) (The oal amoun of Ls) (rofi per one uni of L) = i l c ( υ)( NL )e [r (r ξ)] (B2). Since he losses from NLs are no conemporaneously offse by governmen ransfers, each bank may no have sufficien cash o boh finance is NL losses and pay dividends. I herefore has o cover is losses or cash shorfalls hrough addiional foreign borrowing. Le F i be he level of bank i s cumulaive NL losses or cash shorfalls, which evolves as F i c i i = ( r )F X (B3). Given he fac ha several emerging counries adoped rigid exchange rae regimes before heir crises, i is reasonable o firs assume ha each bank i expecs he governmen o mainain a sable exchange rae and hus does no hedge he foreign exchange (FX) risk associaed wih is foreign borrowing. 8 Thus, in each period, bank i will incur FX profis or losses from is ne foreign borrowing of he amoun FX = (B4). i b i ( i )b Le AFX i be he level of bank i s cumulaive FX profis or losses, which evolves as AFX FX (B5). i c i = ( r )AFX i 8 The model can be exended by relaxing his assumpion. By doing so, a bank s FX hedging will influence he bank s decision on ineres raes and will affec he level of he bank s cumulaive FX profis or losses. 23

32 Since here is a widely held percepion ha governmen guaranees exis and ha he governmen is commied o a sable exchange rae, principal and ineres of banks foreign deb are assumed o be rolled over by foreign crediors every period as long as he level of he counry s inernaional reserves is higher han he expeced level of coningen governmen liabiliies. Based on informaion a he end of period, each bank i chooses he deposi amoun (a i ), he foreign borrowing amoun (b i ), and he lending amoun (e i ) o maximize is expeced profis for period (π B ). π B = Ineres received from Ls Ineres paid o deposiors Ineres paid o foreign crediors Operaing expenses = i i b i i l e ξ - b - i a r - e )r NL (- (B6), subjec o i i i b i i l i i i i i i X ξe b i a r e )r NL ( b b a a e e = (Δ Lending from he end of - o he end of = Δ Deposis Δ Ne foreign borrowing Acual ne income for period Dividends paid o shareholders) (B7), i i i i i F AFX b a e = (Lending a he end of = Deposis Ne foreign borrowing Cumulaive FX profis or losses Cumulaive NL losses or cash shorfalls) (B8), where e i = Bank i's lending o he corporae secor a he end of period, a i = Bank i's deposis a he end of period, b i = Bank i s ne foreign borrowing a he end of period, NL = Fracion of low-ype firms = NLs o oal loans raio a he end of period, r l = Real lending rae for period, 24

33 r = Real deposi rae for period, i b i ξe ( b bˆ ) w = ψ i ψ = Nominal foreign borrowing rae for period, 0 = Bank i s operaing expenses for period (ξ = operaing expense facor), = Real exchange rae a he end of period = Nominal exchange rae divided by price level, X i = Dividends paid by bank i o is shareholders in period (equaion B2), F i = Bank i's cumulaive NL losses a he end of period (equaion B3), FX i = Bank i's FX profis or losses in period (equaion B4), AFX i = Bank i's cumulaive FX profis or losses a he end of period (equaion B5). By rearranging he firs order condiions wih respec o a i and b i, he opimal lending rae equals r = (r ξ) NL (B9), l and he opimal deposi rae is equal o he opimal foreign borrowing rae, i.e., r ( b bˆ ) b c w = i = r = ψ i ψ (B0). 0 Equaions (B9) and (B0) sugges ha in equilibrium each bank deermines he deposi rae o be equal o he foreign borrowing rae required by foreign crediors and ses he lending rae jus o make enough profis from Ls o cover losses from NLs. Also, he domesic ineres raes, boh he lending and deposi raes, are increasing wih he aggregae level of banks ne foreign borrowing and hus serve as an adjusmen mechanism in his model. Hence, if ψ is sufficienly high, he domesic ineres raes will significanly increase during a boom, when he level of invesmen and banks foreign borrowing is high, hereby causing firms o lower heir invesmen and inducing households o deposi more money in banks. 25

34 Noe ha in equilibrium each bank ses is ineres raes jus o earn enough profis from Ls o cover losses from NLs. Hence, is profis from Ls are exacly equal o is losses from NLs. By paying dividends o is shareholders when is expeced profis are zero, in each period, each bank accumulaes NL losses on is accoun of he amoun equal o he dividends paid o is shareholders, i.e., X i = ( - υ) (rofis from Ls) = ( - υ) (Losses from NLs) = ( - υ) (The oal amoun of NLs) (Loss per one uni of NL) i c = ( υ)(nl )e (r ξ) (B). According o equaion (B), parameer υ, i.e., he loan loss provisioning raio, deermines he level of dividends each bank pays o is shareholders as well as he amoun of NL losses each bank accumulaes in each period. Thus, parameer υ can be used as a measure of he degree of he moral hazard a he bank level. The lower he value of υ, he higher he dividends each bank pays o is shareholders, he higher he level of he bank s cumulaive NL losses, and he more severe he moral hazard problem a he bank level Household Secor Assume ha all households are idenical. They work in corporaions or banks and have preferences over consumpion and money holdings. They hold he enire sock of domesic money balances and own boh firms and banks in a well-diversified porfolio. Oher han using heir money for consumpion and money holdings, households inves par of heir savings, cap (K K ) where 0 cap, in newly-issued corporae bonds or socks, which give hem a rae of reurn of r l, and deposi he res in banks, which give hem a rae of reurn of r ( r l ). Hence, in each period, households receive income from he corporae secor in he form of wages, bond or sock reurns from previous period s invesmen, and dividends. They also receive income from he banking secor in he form of salaries, ineres on deposis, and dividends. All household income, excep ineres on 26