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Banking System, International Investors and Central Bank Policy in Emerging Markets

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  • Mariassunta Giannetti

    (Banca d'Italia)

Abstract

This paper argues that the liberalization of capital inflows in a small open economy with a financial system dominated by banks may provoke a soft budget constraint distortion, because large amounts of funds become available at relatively low cost. International investors internalize the risk of accumulation of losses by the banking system only when the risk premium is sufficiently high so as to determine a positive probability that banks will default. This explains why crises occur when massive losses have already been accumulated. In this context, international investors� incomplete information about the types of projects financed by the domestic banking system leads to crises with very similar dynamics, even if the banks are only illiquid, because a temporary increase in the cost of funds may drive illiquid banks to insolvency. This mechanism may explain contagion among countries that are equally rated by international investors but that have different investment opportunities. Finally, the implications of different institutional arrangements for financial stability are examined. In particular, the main source of soft-budget constraint problems in emerging markets is the limited number of lenders and boom-bust cycles may arise even if the central bank does not guarantee deposits.

Suggested Citation

  • Mariassunta Giannetti, 2000. "Banking System, International Investors and Central Bank Policy in Emerging Markets," Temi di discussione (Economic working papers) 369, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:wptemi:td_369_00
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    References listed on IDEAS

    as
    1. Diaz-Alejandro, Carlos, 1985. "Good-bye financial repression, hello financial crash," Journal of Development Economics, Elsevier, vol. 19(1-2), pages 1-24.
    2. Takatoshi Ito & Anne O. Krueger, 1996. "Financial Deregulation and Integration in East Asia," NBER Books, National Bureau of Economic Research, Inc, number ito_96-1.
    3. Ito, Takatoshi & Krueger, Anne O. (ed.), 1996. "Financial Deregulation and Integration in East Asia," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226386713.
    4. Sang-Woo Nam, 1996. "The Principal Transactions Bank System in Korea and a Search for a New Bank-Business Relationship," NBER Chapters, in: Financial Deregulation and Integration in East Asia, pages 277-306, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Fabio Panetta, 2001. "The Stability of the Relation between the Stock Market and Macroeconomic Forces," Temi di discussione (Economic working papers) 393, Bank of Italy, Economic Research and International Relations Area.
    2. Massimo Sbracia & Andrea Zaghini, 2001. "Crises and contagion: the role of the banking system," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 241-260, Bank for International Settlements.
    3. Massimo Sbracia & Andrea Zaghini, 2003. "The Role of the Banking System in the International Transmission of Shocks," The World Economy, Wiley Blackwell, vol. 26(5), pages 727-754, May.
    4. James D Sidaway & John R Bryson, 2002. "Constructing Knowledges of ‘Emerging Markets’: UK-Based Investment Managers and Their Overseas Connections," Environment and Planning A, , vol. 34(3), pages 401-416, March.
    5. SAU, Lino, 2001. "Stato del Credito, Effetto Cash-flow ed Instabilità [State of Credit, Cash-flow Effect and Instability]," MPRA Paper 3641, University Library of Munich, Germany.

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    More about this item

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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