On importing credibility and financial stability: Essays on exchange rates and financial markets

In an open economy, fixing the exchange rate to an anchor currency imports credibility from a foreign central bank. However, do all fixed exchange rate regimes deliver the same credibility benefits? Using VAR techniques, I examine the response of credibility, as captured by interest rate differentials, to domestic and external shocks for a number of currency boards, de jure and de facto pegs, looking for evidence that increased institutional commitment to the exchange rate regime significantly reduces interest rate differentials. Results show that in the face of large negative shocks, devaluation expectations rise just as readily for harder pegs as they do for soft pegs. Overall, evidence suggests that credibility cannot be bought by institutional commitment alone.; Do pegs play a role in financial deepening? Results suggest that pegs in developing countries have a significant and robust effect on financial deepening. Furthermore, the official commitment to a fixed exchange rate regime matters: de facto pegs are relatively unimportant relative to regimes that represent both de facto and de jure pegs. In addition, results show that the positive effect of official pegs is linked to the credibility of the regime: the benefits of the peg diminish as its sustainability diminishes.; Financial deepening is often sought after by opening up domestic financial systems to foreign banks. Thus, I explore the behavior of foreign banks in light of the debate on whether foreign banks ameliorate or worsen the stability of credit, especially during domestic financial crises. I analyze seven developed home countries' bank claims on ten host countries in Latin America since the mid-1980s. Evidence suggests that banks transmit shocks from their home countries and that changes in their claims on other countries spill over to individual hosts. However, as the local presence of foreign banks has increased, foreign bank lending has become more responsive to host country conditions, and responsiveness to the latter becomes less “pro-cyclical” as exposure increases. Foreign bank lending does not appear to retrench during crises and reacts more to positive than to negative host country shocks.