title: Essays in international finance in small, very open economies
Creators: name: Lowe, Shane Rommel
Publisher: name: University of Glasgow
Year: 2022

description: 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.