Capital market development, corporate governance and the credibility of exchange rate pegs

Focusing on emerging market currency arrangements, we build a model of an exchange rate peg with escape clauses and output persistence. We first show how output persistence works as an additional 'fundamental' so that an exogenous increase in persistence can make the currency peg more vulnerable to speculative attacks. We then endogenise output persistence as arising from capital market frictions that are caused by weak corporate governance institutions. It turns out that in emerging market economies, often characterised by credit constraints, a partial reform of corporate governance institutions may enhance a financial accelerator mechanism, which increases output persistence and deteriorates the credibility of the exchange rate peg. A conservative policymaker partially counters this adverse effect, but only a complete reform of corporate governance institutions fully eliminates persistence and reduces the risk of currency crisis on all levels of policy preferences. JEL Classification: E58, F33, D84, G18, G38

Variable rate liquidity tenders

This paper constructs an equilibrium model for the short-term money market, when the central bank provides liquidity via variable rate tenders. The relation between market rate of interest and liquidity is derived from a single bank’s profit maximisation problem in the interbank market, and the CB determines its liquidity provision by minimising a quadratic loss function that contains both deviations of expected market rate from CB target rate and differences between liquidity supply and target liquidity. We model equilibrium bid behaviour in the tenders and explain the underbidding phenomenon resulting from the minimum bid rate. We also show that, when maturities of consecutive operations overlap, the expected market interest rate will rise above the CB’s target whenever a target rate change (hike or cut) is expected to occur in the same reserve maintenance period. Finally, we review the data from the ECB variable rate tenders and find that the ECB has been fairly liquidity oriented in its allotment decisions.money market tenders; liquidity policy; bidding; central bank operational framework

Variable rate liquidity tenders

This paper constructs an equilibrium model for the short-term money market, when the central bank provides liquidity via variable rate tenders. The relation between market rate of interest and liquidity is derived from a single bank’s profit maximisation problem in the interbank market, and the CB determines its liquidity provision by minimising a quadratic loss function that contains both deviations of expected market rate from CB target rate and differences between liquidity supply and target liquidity. We model equilibrium bid behaviour in the tenders and explain the underbidding phenomenon resulting from the minimum bid rate. We also show that, when maturities of consecutive operations overlap, the expected market interest rate will rise above the CB’s target whenever a target rate change (hike or cut) is expected to occur in the same reserve maintenance period. Finally, we review the data from the ECB variable rate tenders and find that the ECB has been fairly liquidity oriented in its allotment decisions.money market tenders, liquidity policy, bidding, central bank operational framework

Labour market reform and the sustainability of exchange rate pegs

It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalise this notion by incorporating labour market rigidities into an 'escape clause' model of currency crises. We show that the absence of structural reform makes a currency peg more fragile and undermines the credibility of the monetary authority in a dynamic setting. The fragility is captured by a devaluation premium in expectations that increases the average inflation rate when the currency peg is more vulnerable to 'busts' than 'booms'. This interaction between macroeconomic and microeconomic rigidities suggests that a policy reform can only be consistent if it renders either exchange rates or labour markets flexible.exchange rate policy; labour market flexibility; structural reform

Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments

I explore the dynamics in overlapping generations models with pure exchange and lump-sum taxes, when the second period after tax endowment is negative, and contrast the characteristics of equilibria to those of models with positive after tax endowments. In particular, if the intertemporal elasticity of substitution is less than unity, there can be only a two cycle or stable (ie indeterminate) equilibria for certain parameter values. With this value for that elasticity chaos and a cycle of any order can occur in a model with regular endowments. In a sense the lump-sum taxation in this model operates as a stabilizing device. The precise stability condition holds with a small discount factor and in economies with relatively high taxes in the first period. If the intertemporal elasticity of substitution is greater than unity, the steady state equilibria are unstable, and thus determinate, as is the case with the regular model.overlapping generations economy; saving; cycles; lump-sum taxation

Candidate Quality

We analyze the topical question of how the compensation of elected politicians affects the set of citizens choosing to run. To this end, we develop a sparse and tractable citizen-candidate model of representative democracy with ability differences, informative campaigning and political parties. Our results suggest that primaries, campaign costs and rewards have previously overlooked interactions that should be studied in a unified framework. Surprisingly, increasing the reward may lower the average candidate quality when the campaigning costs are sufficiently high.Politicians' competence; Career concerns; Campaigning costs; Rewards for elected officials; Citizen-candidate models

Optimal bank transparency

Consider a competitive bank whose illiquid asset portfolio is funded by short-term debt that has to be refinanced before the asset matures. We show that in this setting maximal transparency is not socially optimal, and that the existence of social externalities of bank failures further lowers the optimal level of transparency. Moreover, asset risk taking recedes as the level of transparency declines towards the socially optimal level. As for the sign of the transparency impact on refinancing risk, it is negative given the risk associated with the asset, but ambiguous if one accounts for its indirect effect via risk taking.financial stability; information disclosure; market discipline; Basel III; global games

Capital Market Development, Corporate Governance and the Credibility of Exchange Rate Pegs

We build a model of a fixed exchange rate regime with escape clauses and output persistence. In the spirit of the literature following the Asian crisis in 1997, persistence in our model arises from the inability of the domestic financial institutions to intermediate international credit. Our main message is that since persistence generates long run credibility effects that are sensitive to the prevailing policy preferences, the choice of an optimal exchange rate regime and the preference for a policy target should reflect the degree of development of the domestic financial institutions. If the domestic financial market suffers from credit constraints that generate persistence, the likelihood of self-fulfilling currency crisis may be reduced if the government assigns a greater weight on the output stabilisation objective. However, if financial market liberalisation successfully eliminates the credit constraints, liberalisation should be associated with a switch in policy preferences more in favour of exchange rate stability.

Law and stock markets: evidence from an emerging market

A sweeping and protracted reform of corporate law took place in Finland in the 1970s. The reform brought significant improvements to investor protection and, similar to the US Sarbanes-Oxley Act, tightened disclosure rules at the cost of increasing the work load in corporate reporting. We find that the Finnish stock market generally reacts negatively to news of tightened disclosure rules and increased work loads, whereas news of delays in implementation of reform were largely positive. This raises the question of whether strengthening investor protection by requiring greater transparency necessarily promotes the development of financial markets. It also serves to remind that the implementation costs of reforms should not be overlooked.corporate governance; investor protection; law and finance; transparency; Sarbanes-Oxley Act

Phoenix rising: Legal reforms and changes in valuations in Finland during the economic crisis

Finland experienced an extremely severe economic depression in the early 1990s. In the midst of this crisis, significant new legislation was passed that increased supervisory powers of financial market regulators and reformed bankruptcy procedures, significantly decreasing the protection of creditors. We show that the introduction of these new laws resulted in positive abnormal stock returns. The new laws also lead to increases in firms’ Tobin’s q, especially for more levered firms. In contrast to previous studies, our results also suggest that public supervision of financial markets fosters rather than hampers financial market development.corporate governance; bankruptcy; financial supervision; shareholder protection; creditors’ rights; corpo-rate valuations; political economy