The world financial and economic crisis that began in 2007 has once again brought to the fore a perennial and unresolved question in international economics: what is the optimal level of capital account openness for emerging market economies? In this dissertation, I attempt to address this and related questions of interest to the emerging market policymakers. An important reason why the question of optimal level of openness remains unresolved is that we have only imperfect measures of the true degree of openness. In theory, a defining characteristic of integrated markets is that identical goods or assets carry the same prices everywhere, but in practice, economists do not yet have a measure that allows them to rank economies based on the extent to which their financial markets show price-convergence with the world market. In the first chapter, I propose such an index. This index identifies greater openness of an economy with greater convergence of its interest rates with the world interest rates. More specifically, this index measures deviations from covered interest parity. These deviations are modeled using an Asymmetric Self-Exciting Threshold Autoregressive Model (ASETAR). A key result of this chapter is that while all the emerging markets are less integrated than the developed markets, in none of them are deviations from parity such as to reject efficient arbitrage.

Next, I explore the linkages between the development of the domestic financial sector of an economy and its financial integration with the rest of the world. I find that even in a world free of transactions costs and counter-party risks, capital controls alone are not sufficient to cause real interest rates differentials to exist in equilibrium. I also show that liberalization of the domestic financial sector by emerging economies in the past decade had a role to play in their growing current account imbalances. Several predictions of the model are confirmed by data on low and middle income countries. The impact of financially repressive policies of the developing country governments on interest differentials and current account imbalances is a little studied topic in international finance, and this chapter is an attempt to cover some ground here.

As the crisis spread from the United States to the rest of the world, the Federal Reserve took the unprecedented step of offering US dollar swap lines to four emerging markets on October 2008. The final chapter in my dissertation tries to identify the selection criteria for the unprecedented swap lines extended by the Federal Reserve to four emerging markets in October 2008. It also assesses the impact that these lines had on the emerging markets exchange rates and default risk as perceived by the markets. The most important variable determining inclusion of an emerging market is the exposure of US banks to these markets, and not the degree of capital account openness of the country. This indicates that openness itself need not imply vulnerability to crisis.