Essays on financial integration and institutional quality

This thesis comprises four individual essays and deals with the question of how international financial integration may influence quality of economic institutions in developing countries. While the first three essays provide theoretical models of different channels, through which financial integration may affect institutional quality, the last work is an empirical investigation into the influence of liberalization of the financial account on institutional development. The first essay „Financial Integration in Autocracies: Greasing the Wheel or More to Steal?“ analyzes the influence of financial integration on institutional quality in an autocratically ruled economy. The essay provides a dynamic political-economic model in which a ruling elite uses its political power to expropriate the general population. Although financial integration reduces capital costs for entrepreneurs and thereby raises gross incomes in the private sector, the elite may counteract this effect by increasing the rate of expropriation. Since de facto political power is linked to economic resources, financial integration also has long run consequences for the distribution of power and for the rise of an entrepreneurial class. The second essay “Autocracies, Structure of the Economy, and Expropriation” also develops a model on elite's behavior in autocratically ruled economies. In contrast to the previous model, the ruling elite is also involved in the economic production process. The elite imposes a distortive tax on the entrepreneurial income in order to i) extract rents and ii) to influence the factor prices of the input factors increasing thereby its own economic profits. The structure of the economy is captured by the degree of complementarity between the production inputs provided by the general population and determines the extent of expropriation. The less dependent the elite is on the entrepreneurial activity, the higher is the equilibrium rate of expropriation. The results also show that a rise in the entrepreneurs' productivity, which may result from financial integration, raises the expropriation rate, this effect being stronger for lower values of the complementary parameter. The third essay “Mode of International Investment and Exogenous Risk of Expropriation” analyzes the relationship between the mode of international investment and institutional quality. The model assumes that foreign investors from a capital-rich North can either purchase productive assets in a capital-poor South and transfer their capital within integrated multinational firms (foreign direct investment) or they can form joint ventures with local asset owners. The South is ruled by an autocratic elite that may use its political power to expropriate productive assets. The expropriation risk lowers the incentive to provide specific capital in an integrated firm and distorts the decision between joint ventures and integrated production. By setting the institutional framework in the host country, the elite influences the risk of expropriation and thereby the resulting pattern of international production. Financial integration, which is reflected in a decline in investment costs, has an asymmetric effect on the equilibrium risk of expropriation: A decline in the costs of forming a joint venture raises the risk of expropriation, whereas a decline in the costs of foreign direct investments lowers it. The fourth essay “Financial Liberalization and Institutional Development” empirically analyzes the effects of de jure financial openness on institutional quality as captured by indicators on investment risk, corruption level, impartiality of judiciary system as well as the effectiveness of bureaucratic authorities. The results show that a higher degree of financial openness improves institutional quality in particular by reducing investment risks. However, according to the findings, financial liberalization may also lead to an increase in the level of corruption. In addition, the results show that if financial liberalization is supported by simultaneous political liberalization, the benign consequences of financial opening for the institutional performance are even larger, while financial deregulation in former socialist countries tends to worsen institutional quality