Essays in international finance in small, very open economies

The three essays which make up this thesis seek to evaluate how accounting for the unique structure of the world’s smallest and most open economies affects standard macroeconomic relationships and models in international finance. These countries’ vulnerabilities to external shocks, limited production capacity and their dependence on imports of goods and services for consumption and investment leave them exposed to excessive consumption volatility. Moreover, their choice of exchange rate regime may further complicate how they choose to manage and respond to external shocks. Consumption theory advocates that consumers will seek to smooth consumption over their lifetime, while international risk sharing implies a positive and perfect correlation between relative consumption and the real exchange rate. However, substantial research has identified numerous examples of low or negative correlations between consumption and the real exchange rate, a phenomenon now known as the Backus-Smith puzzle. While several authors have sought to reconcile what has become an empirical regularity with theory, most perform these tests primarily for members of the Organisation for Economic Co-operation and Development or more developed economies. The first essay (Chapter 2) sought to empirically evaluate whether the degree of home bias for given values of the elasticity of substitution between domestic and foreign tradables helps to explain the Backus-Smith puzzle (as suggested in Corsetti et al. (2008)) for a diverse group of 150 countries. The results suggest that the Backus-Smith puzzle disappears for a group of more open economies. This is particularly evident for countries whose average imports of goods and services relative to nominal gross domestic product exceed 44%. These results highlight the importance of accounting for nonlinearity and country heterogeneity when testing economic theories of small open economies. Since the 1990s, emerging markets and developing economies have accumulated substantial stocks of foreign exchange reserves to act as buffers against external shocks. However, increasingly, several authors have emphasized a role for foreign exchange reserves in reducing the probability of a sudden stop to capital inflows and the resulting roll-over risk of upcoming debt maturities. Yet, while some research has studied the role of foreign exchange reserves in reducing the marginal cost of borrowing (see Levy Yeyati (2008) and Bianchi et al. (2018) for example) and advocate some role for countries to borrow to ‘top up’ foreign exchange reserves for precautionary purposes and reduce default risk and sovereign risk premiums, few identify whether this relationship varies with existing external debt or foreign exchange reserves levels or whether it varies across different types of countries or economic structures. For example, stylized facts presented in the second essay (Chapter 3) suggest that countries with more stable exchange rate regimes appear to exhibit a greater relationship between foreign exchange reserves and sovereign bond spreads than countries with more flexible exchange rate regimes. Thus, Chapter 3 seeks to ascertain the role of foreign exchange reserves in reducing the spreads on external sovereign bonds and to determine whether that effect varies as external debt levels rise and across exchange rate regimes. Leveraging data for 28 emerging markets and developing economies, Chapter 3 finds evidence that a larger stock of foreign exchange reserves reduces sovereign bond spreads, particularly in markets with more stable exchange rates. However, this relationship becomes statistically insignificant once external government debt levels exceed 33% of nominal gross domestic product (GDP). Further, while Chapter 3 presents evidence that countries can borrow to accumulate foreign exchange reserves and reduce bond spreads, countries with less flexible exchange rates stand to benefit more from this than their counterparts with more flexible exchange rate regimes. The determinants of currency and debt crises are well researched, and several studies have yielded consistent results outlining the major predictors of these events. However, while some authors have sought to distinguish between the most important predictors depending on exchange rate regime, few, if any, seem to have investigated how these relationships vary by economic structure. In fact, the third essay (Chapter 4) hypothesizes that, due to differences in the degree of trade openness or country size, policymakers across economies may face tradeoffs when choosing between nominal exchange rate devaluation and default on external or foreign currency debt when deciding how best to correct for large macroeconomic imbalances. Chapter 4 contributes to the literature in two ways. First, it seeks to determine whether the predictability of real exchange rate overvaluation, a common measure of external imbalances and a key predictor of currency crises, varies, not only by the exchange rate regime, but also by the degree of trade openness and population size. Secondly, it assesses whether a country’s choice to default on foreign currency obligations rather than to devalue its nominal exchange rate considering macroeconomic imbalances varies by the country’s size or the degree of trade openness. The findings in this essay provide some evidence that for given levels of real exchange rate overvaluation, smaller, more open economies with fixed or managed exchange rates are less susceptible to currency crashes than larger, less open markets. This result is especially evident when the degree of real exchange rate overvaluation exceeds 24% but becomes statistically insignificant for small, open economies when real misalignment exceeds 35%. Further, when faced with real exchange rate overvaluation or other macroeconomic imbalances, the governments of smaller, more open economies are more likely to choose to default on their foreign currency debt rather than to devalue their nominal exchange rates, compared to their larger, less open counterparts. Finally, the insights gleaned from this thesis suggest that policymakers should account for an economy’s unique structure and inherent vulnerabilities when designing economic policies. Moreover, they justify the need for academics to incorporate additional country heterogeneities into their models of the small, very open economy

Tracing the Liquidity Effects on Bank Stability in Barbados

This paper provides a micro-economic approach to evaluating bank stability in the face of adverse liquidity conditions. Specifically, it examines the potential for systemic risk as a result of liquidity shocks on each bank. According to Nier et al., (2008) systemic risk results when the failure of multiple banks imposes significant costs on the entire economy. This assessment is done by tracing the liquidity effect across institutions based on the degree of exposure among commercial banks. In this study, a bank with an after-shock capital adequacy ratio (CAR) less than 8 percent is assumed to require additional capital. In addition, systemic risk rises when the CAR of the entire banking sector converges to the 8 percent threshold. Overall, the results suggest that banks in Barbados are well capitalised and are able to withstand significant liquidity shocks. In addition, the study found that banks can be ranked in terms of systemic importance. Consequently, the second-round effects that result from systemically important banks tend to have large impacts with significant implications for bank stability

Tracing the Liquidity Effects on Bank Stability in Barbados

This paper provides a micro-economic approach to evaluating bank stability in the face of adverse liquidity conditions. Specifically, it examines the potential for systemic risk as a result of liquidity shocks on each bank. According to Nier et al., (2008) systemic risk results when the failure of multiple banks imposes significant costs on the entire economy. This assessment is done by tracing the liquidity effect across institutions based on the degree of exposure among commercial banks. In this study, a bank with an after-shock capital adequacy ratio (CAR) less than 8 percent is assumed to require additional capital. In addition, systemic risk rises when the CAR of the entire banking sector converges to the 8 percent threshold. Overall, the results suggest that banks in Barbados are well capitalised and are able to withstand significant liquidity shocks. In addition, the study found that banks can be ranked in terms of systemic importance. Consequently, the second-round effects that result from systemically important banks tend to have large impacts with significant implications for bank stability

Growth Forecasts for Foreign Exchange Constrained Economies

Insufficiency of foreign exchange may at times constrain the growth of small open economies which lack the domestic resources to produce import substitutes for their consumption, investment and input needs. This study explores the foreign exchange constraint in three small open Caribbean economies, using a structural model of the relationship of foreign exchange earnings and growth, and the economies’ openness to international markets. The model is used to evaluate the prospects of economic growth for these economies, based on the forecast availability of foreign exchange

The effectiveness of government expenditure on education and health care in the Caribbean

Investment in human development is considered a means of improving the quality of life and sustaining economic growth in the Caribbean. The purpose of this paper is to assess the efficacy of public spending on health care and education by evaluating the life expectancy and school enrolment rates of these countries

Do Tourism Receipts Contribute to the Sustainability of Current Account Deficits: A Case Study of Barbados

Given Barbados’ recent history of persistent current account deficits and reliance on tourism as a major source of foreign exchange and driver of the economy, this paper investigated the contribution of tourism receipts to the sustainability of Barbados’ current account deficits. Utilizing an inter-temporal budget approach, it was found that Barbados’ current account deficits were weakly sustainable as a result of tourism’s contribution, underscoring the island’s dependence on the industry

Do Tourism Receipts Contribute to the Sustainability of Current Account Deficits: A Case Study of Barbados

Given Barbados’ recent history of persistent current account deficits and reliance on tourism as a major source of foreign exchange and driver of the economy, this paper investigated the contribution of tourism receipts to the sustainability of Barbados’ current account deficits. Utilizing an inter-temporal budget approach, it was found that Barbados’ current account deficits were weakly sustainable as a result of tourism’s contribution, underscoring the island’s dependence on the industry

Growth Forecasts for Foreign Exchange Constrained Economies

Insufficiency of foreign exchange may at times constrain the growth of small open economies which lack the domestic resources to produce import substitutes for their consumption, investment and input needs. This study explores the foreign exchange constraint in three small open Caribbean economies, using a structural model of the relationship of foreign exchange earnings and growth, and the economies’ openness to international markets. The model is used to evaluate the prospects of economic growth for these economies, based on the forecast availability of foreign exchange

Does crime depend on the ‘state’ of economic misery?

This paper examines the impact of economic misery on criminal activity the small island state, Barbados, using Markov-switching models. No evidence of a contemporaneous relationship between economic misery and crime was uncovered. On the other hand, Property and Theft of Motor crime respond to the state of misery with a lag of one period, supporting the criminal motivation effect. Economic misery is in the same regime as Property crime 50 percent of the time, and with Theft from Motor crime almost 60 percent of the time. There is a procyclical contemporaneous relationship between inflation and Property crime, lasting up to two periods. Unemployment’s impact on Theft of Motor crime manifests after three periods, and supports the criminal opportunity hypothesis. Finally, Fraud-related crime and unemployment are concordant. Typical demand side policies to reduce the level of misery may not have the desired effect on crime, as reducing the unemployment rate or inflation rate respectively, could lead to an increase in the rate of crime, via the Phillips curve relationship. The most promising course of action may be supply side policies, designed to improve the long-run performance of the economy