Resolving the Interest Rate Premium Puzzle: Capital Inflows and Bank Intermediation in Emerging Economies

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Abstract
Increasing capital inflows and sustained interest rate spreads were important features in East Asia prior to the crisis of 1997-98. But why did capital inflows fail to eliminate interest rate differentials? Why were inflows associated with rising domestic interest rates that then perpetuated the inflows and made the bust that much more severe when it occurred? It is these questions that are analyzed in this paper. Standard macroeconomic theory has, by and large, either ignored the role of banks in the intermediation process or implicitly assumed it to be smoothly functioning. Neither alternative is satisfactory, particularly with regard to emerging economies in East Asia, as it is through financially weak banks that a large part of capital inflows has been intermediated. The paper develops a simple bank-based analytical framework to explain why and how capital inflow surges and lending booms could lead to higher real interest rates in the domestic economy, even after adjusting for country/currency risk premia and exchange rate changes. An important policy conclusion that stems for the analysis is that the internationalization of banks should be encouraged in the advance of capital account deregulation.