11/1/2016
Political
Economy and
Exchange
Rate Regimes:
Developing Countries’
Exchange Rate Regime Choice
in a Post-Crisis Scenario
Martin Belchev: Student Number S2570866
UNIVERSITY OF GRONINGEN Thesis Supervisor: Dr. Herman Hoen Course: International Political Economy
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DECLARAION BY CANDIDATE
I hereby declare that this thesis, “International Political Economy and Exchange Rate Regimes in Developing Countries: Exchange Rate Regime Choice in Post-Crisis Environment”, is my own work and my own effort 5
and that it has not been accepted anywhere else for the award of any other degree or diploma. Where sources of information have been used, they have been acknowledged.
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Content
1. Introduction: The Choice of an Exchange Rate Regime and the Institutionalist Framework ... 5
2. Methodology and Structure of the Thesis ... 11
3. Exchange Rate Regimes ... 13
5 3.1 Fixed Exchange Rate Regimes ... 14
3.2 Flexible Exchange Rate Regimes ... 16
3.3 The Economic Trilemma and Exchange Rate Regimes ... 18
3.3 Intermediary Exchange Rate Regimes ... 21
4. Exchange Rate Regime Choice Theories and Developing Countries ... 25
10 4.1 Mundell-Fleming Framework... 26
4.3 Bi-polar Hypothesis/Hollow Middle Theory ... 29
4.4 Exchange Rate Regime Choice for Developing Countries- Towards an Institutionalist Approach ... 30
5. Fear of Floating ... 33
5.1 Currency Devaluation ... 33
15 5.2 Economic Effects of Devaluations ... 33
5.3 Political Implications of Devaluations ... 35
5.4 Fear of Floating ... 38
6. Currency Crises and their implications for Developing Countries ... 40
6.2 First Generation Model of Currency Crises ... 40
20 6.3 Second Generation Crisis Model ... 42
6.3 Third Generation Model ... 44
a. Twin Crises ... 45
7. Pre and Post Crisis Exchange Rate Regimes in Indonesia, Philippines, Malaysia and Thailand ... 47
7.1 The Crisis of 1997 and Exchange Rate Arrangements ... 47
25 7.2 Post-Crisis Arrangements- Fear of floating ... 50
7.3 Conclusions ... 56
8. Interest Groups Classification, Political Interests and Exchange Rate Regimes – An Institutionalist Approach ... 57
8.1 Interest Groups in Favor of Fixed Exchange Rates ... 58
30 8. 2 Interest Groups in Favor of Flexible Exchange Rate Regimes ... 59
8.3 Authoritarian Vs Democratic Regimes ... 61
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b. Democratic Regimes ... 63
c. The Role of Political Instability in Democracies and Exchange Rate Regimes ... 64
8.4 Hypothesis II and Hypothesis III ... 66
9. Case Study: Thailand and Malaysia ... 67
9.1 Case Study: Introduction ... 67
5 9.2 Thailand and the Asian Crisis of 1997 ... 68
a. Thai Government’s Response to the Crisis ... 71
b. Interest Groups in Thailand ... 72
c. Interest Groups and Power Balance in Thailand ... 75
9.3 Malaysia and the Asian Crisis of 1997 ... 77
10 a. The Malaysian Government’s Response to the crisis and Political Change ... 81
b. Malaysia and Interest Groups- Prior and After the Crisis ... 82
10. Conclusion ... 85
List of References: ... 91 15
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Abstract:
The problem of choosing an optimal exchange rate regime is crucial policy area and it can have a lasting effect on both the volumes of trade and investments, and can have important implications for the levels of external debt. Therefore, an efficient choice of an exchange rate regime is strongly correlated with the way developing states are integrated on the international arena and thus this
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has profound implications for the field of international relations. Events such as the Asian Financial Crisis of 1997 and the Argentinian crisis indicate that developing countries often implement economic policy inconsistencies, which can lead to a severe financial and currency crisis. As such the aim of this thesis is to examine the factors that lead to the exchange rate regime choice adopted by developing countries in a post-crisis environment. The research has employed a
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rational institutionalist analysist in addressing the research objectives and it has been argued that developing countries are reluctant to let their currency float on the financial markets, which can be explained by the specific characteristics of their economies and domestic political processes. In addition, it will be argued that interest groups in democratic regimes can put pressure on their respective governments and essentially influence the choice of an exchange rate regime. Finally,
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the thesis has identified that less democratic or authoritarian regimes, are more likely to stick to their officially announced exchange rate regime, as they are both better insulated against the pressure of domestic interest groups and use the regime as a source of credibility and monetary stability.
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1. Introduction: The Choice of an Exchange
Rate Regime and the Institutionalist
Framework
Choosing an exchange rate regime is one of the most important policies a government must undertake, as it forms a crucial set of policy tools and institutional arrangements through which a 5
state is integrated within the international markets (MacDonald, 2007). The exchange rate regime, is in effect a system, which dictates how the domestic currency is managed against foreign currency (Macondald, 2007). Auboin and Ruta (2012: 3) point out that the real exchange rates, represent the “relative prices of tradable to non-tradable products”, and are a key component of the economic policy and that can influence the overall economic performance through numerous channels such 10
as trade, allocation of capital and labour between the tradable and the non-tradable sectors, capital inflows and outflows, and asset prices. Thus, implementing an effective exchange rate regime can have a significant effect on growth, best illustrated by the rapid economic development of the East Asian countries. “An exchange rate that made exporting relatively attractive was clearly a key component of East Asian countries’ rapid economic growth over the past several decades 15
(Takatoshi and Krueger, 1999: 1)”. Therefore, the process of crafting effective exchange rate regime policy is of utmost importance to a wide range of both national and international factors such economic output, trade and bilateral/multilateral relations (Auboin and Ruta, 2012). A good example of the latter, is the inception of the international monetary system during the nineteenth century with the attempt to structure and organise monetary policy by implementing a “classical” 20
gold standard (Kettel, 2004). Its introduction resulted in an unprecedented thus far level of monetary stability and economic growth for its participants until its collapse with the outbreak of the First World War. The subsequent attempts to establish a new stable exchange rate system have led to the creation of the Bretton Woods, which introduced fixed yet adjustable exchange rates leading to a new period of stability and “presided over the greatest boom in the history of global capitalism 25
P a g e 6 | 104 as the EU, points out to the fact that monetary policy can be perceived as a key variable in both national and international policy-making (Kettel 2004). The logic is also valid for the developing countries, which often use their respective exchange rate regimes to strengthen their competitiveness on the international markets or to reduce price volatility (Kettel, 2004).
Increased capital volatility and liberalization, however, put serious pressure on the 5
currencies of developing countries. Events such as the Mexican ‘tequila crises’, the Argentinian economic crisis and the Asian crisis of 1997 have exposed how volatility and market failure can undermine development, growth and political stability in emerging markets. “Financial crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion and changes in the perceived risk of investing in certain currencies (Kohler, 2010; 39)”. 10
The rapid depreciations of real exchange rates are referred as currency crises in the academia and can have considerable implications for both the domestic economy and the political system of a given country, such as reduced investments, capital outflows and political instability. Particularly, the developing countries are vulnerable to exchange rate shocks, since currency crises are often preceded by banking sector collapses and problems, following the aftermath of financial 15
liberalization (Kaminsky and Reinhart, 1999). According to LeBlang (2003), these vulnerabilities are enhanced further, since despite the economic liberalisation many, developing countries still use exchange rate policy as a buffer between domestic and international markets, which makes their currencies vulnerable to capital flows.
A collapse of an exchange rate regime implies that a given country will have to adopt more 20
flexible monetary arrangement in order to meet the new economic realities (LeBlang, 2003). However, the existing theories such as the fear of floating hypothesis point out that developing countries in general are reluctant to let their currency float in an attempt to avoid the increased volatility of the real exchange rate, caused by the movement of capital. Such practices result in what economists refer to as a de jure exchange rate regime, or the one officially announced, and de 25
facto exchange rate regime, the one actually pursued by the government of a given country
P a g e 7 | 104 analysts focus mainly on the model of optimum currency area, which presupposes that an optimum currency choice for regions can be made on the basis of various economic criteria, such as a country’s size, trade openness and factor mobility. The Capital Account Openness Hypothesis,
which became prominent in the 90s of the 20th century, offers another approach to the choice of an
exchange rate regime (IMF, 2003). The main argument of the hypothesis is that due to the increased 5
capital mobility, countries with open capital accounts are forced to either undertake a hard peg in the form of currency boards or currency unions, or to adopt a pure float (Eichengreen, 1994; Fischer, 2001).
Another set of determinants that can potentially influence the choice of an exchange rate regime has been the institutional and historical characteristics of the state (Edwards, 1996; Poirson, 10
2001). These factors are a subject of analysis of political institutionalism, which involves an examination of variables such as political stability, inflationary bias, central bank stability, institutional quality and the specifics of the domestic political economy (Bearce, 2003). Rational choice institutionalism, in particular, poses an interesting proposition in regards tothe field of international relations and international political economy, as it encompasses the utility-15
maximizing approach, typical of the classical economics. Institutional analysis, combined with the rational choice theory, assumes that utility-maximizing social actors and states “are central actors in the political process, and that institutions emerge as a result of their interdependence, strategic interaction and collective action or contracting dilemmas (Pierre et al., 2008; 10)”. Furthermore, institutions are established and continuously reformed, as they fulfil certain functions for these 20
social actors and provide certain stability and order within the system.
Rational institutionalism is strongly influenced by the theory of transaction costs, which claims that arrangement (or contract) involves costs not only in terms of resources, but also in terms of negotiating and enforcing it. Under these arrangements, institutions provide an opportunity to lower transaction costs (Pierre et al., 2008). In other words, institutions serve to provide policy 25
P a g e 8 | 104 institutional arrangement have a considerable impact on the choice of an exchange rate regime. In effect, rational institutionalist theory provides a theoretical framework through which addresses the impact of the economic and political variables on a given policy choice, and the choice of an exchange rate regime is no exception. In fact, an institutionalist analysis provides a viable alternative for analysing exchange rate regime choice in a post crisis environment, as it provides an 5
insight on the social and political dynamics that shape this choice after the collapse of the real exchange rate. As such, an institutionalist approach can be useful in uncovering the correlation between political processes and economic policy, when it comes to exchange rate regime choice, thus providing an international political economy and international relations perspective on the issue.
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The implications posed by the choice of an exchange rate regime, however, traditionally fit within the theoretical framework of neoliberalism in international relation, namely that affairs between states is conducted through various channels, including economic transactions, which create a certain amount of interdependence between international actors (Axelrode and Keohane, 1985). However, the traditional neoliberal framework focuses on the notion that states establish 15
international regimes, the aim of which is to establish a formal structure of rules in the anarchic environment that is the international system (Keohane and Milner, 1996). Under this perspective, exchange rate regimes can be perceived as channel of economic exchange, which leads to the establishment of a certain degree of interdependence between states. Yet, when it comes to exchange rate regimes, even though international regimes have been established in the past, when 20
it comes to exchange rate regimes, such as the Bretton Woods system, they have resulted in a failure and the issue has remained confined as a unit of analysis mainly in the field of economics. As such, even though neoliberal theory perceives exchange rate regimes as a crucial economic channel, through which international relations between states is established, it fails to provide a theoretical framework, which would explain how exchange rate regimes are determined, as it fails to take in 25
P a g e 9 | 104 The research will, therefore, implement a rational institutionalist analysis of exchange rate regime in a post-crisis environment in order to examine whether the fear of floating hypothesis still holds in a post-crisis environment and in what way the choice of an exchange rate regime depends on domestic political actors and interest groups. An institutionalist framework provides an analytical framework, which can explain how the choice of exchange rate regimes are influenced 5
both on a national and international level, as it takes in account economic and political interests. Furthermore, the research will focus on a case study analysis of the Asian financial crisis in 1997 and on Thailand and Malaysia in particular. The two countries have been chosen as a focus of this research due to the fact that while Thailand has had a functioning democracy, the Malaysian government has a distinctive authoritarian character, and thus this will allow the research to uncover 10
the extent to which a specific political regime influences the behaviour of domestic actors in regards to exchange rate regime choice. The research will employ a comparative method of difference in order to examine how the political arrangements of a democratic and an authoritarian regime influence the choice of an exchange rate regime in a post-crisis environment. The thesis will argue that the choice of an exchange rate regime in developing countries in a post-crisis is dependent on 15
the political processes and institutional arrangements within a given developing country. Finally, as it was established, exchange rate regimes play a crucial part in a number of spheres of traditional interest to international relations scholars, so it must be pointed out that the research will address the research objectives through the lenses of international political economy and international relations theories, in order to expand upon existing literature on the subject, address existing 20
literature gaps and provide a theoretical framework on the subject.
1.1 Hypotheses- Exchange Rate Regimes in а Post-Crisis Scenario
Market liberalization and openness to capital flows in the last 20 years has put pressure on the currency exchange rate regimes of developing countries (Yagci, 2001) ‘’Favourable country prospects invite large capital flows leading to over-borrowing and unsustainable asset price booms 25
particularly when prudential supervision in the financial sector is weak (Yagci, 2001; 11)’’. Three hypotheses will be made and thoroughly examined. The research will thus try to provide a comprehensive overview of why developing states behave in a certain way in a post-crisis environment. It will be shown that political processes and actors play a vital part of the decision making process in regards to the choice exchange rate regime in a post-crisis environment.
P a g e 10 | 104 Hypothesis 1 - The first hypothesis that will be proposed in this research is that the exchange rate regime that governments in developing countries in a post crisis scenario will adopt is different from the one that is initially announced. In other words, these governments will be reluctant to let their currencies float on the financial markets (Diagram 1). Calvo and Reinhart (2000) refer to such behavior as a fear of floating and it represents the reluctance of countries, and their respective 5
governments to allow their currencies to float freely on the financial markets during non-crisis times, which normally can be attributed to the specific characteristics of various exchange rate regimes, the development policies of developing countries, and the quality of their institutions. The first hypothesis, then proposed that the same behavior can be noticed even after the collapse of the currency.
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Hypothesis 2 – Fear of floating cannot be attributed to economic factors alone. This hypothesis argues that the institutional arrangements of a state, play a large role in determining the exchange rate of a developing country in a post crisis scenario, i.e. economic actors, industries and interest groups have an interest to directly influence the choice of a de facto exchange rate, as they are utility maximizers.
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Hypothesis 3- The third hypothesis made in this thesis argues that authoritarian regimes in developing countries are more likely to stick to their officially announced regime in a post-crisis environment due to two factors. The first factor can be attributed to the fact that they are better insulated against political domestic pressures, occurring after a crisis episode and as such they do not need to depoliticize the issue. The second factor can be attributed to the lack of transparency 20
P a g e 11 | 104 Diagram 1- Hypothesis 1
2. Methodology and Structure of the Thesis
This thesis focuses on examining both primary and secondary data in order to address the proposed hypothesis, and will examine data and theories by scholars, academics and professionals 5
in journals, books and policy papers, combining them with quantitative data from official reports form international institutions and organisations, such as the IMF, in order to address the core of the research and support the arguments made. The thesis will undertake both a qualitative and quantitative analysis in examining the validity of the hypotheses. Cole et al. (2005) argues that qualitative data is suitable in examining the validity of already grounded theories and employing 10
quantitative data is beneficial in building upon these theories. The main research strategy employed by the thesis will be a combined pragmatic qualitative and quantitative method (Cole et al., 2005). Using this method is suitable in analysing real world data and can be used in building up a logical policy prediction (Liavari and Venable, 2009). Pragmatic research does not rely on specific research philosophy, but rather employs a mixed method approach to the research objectives in order to 15
P a g e 12 | 104 objectives and hypotheses will be done in the most suitable method possible. Furthermore, pragmatic research design recognizes the fact that certain policies and social actors exist in a world shaped by political, economic and historical processes. This fact is true for the overarching topic of this thesis, as exchange rate regime policy is certainly dependent on a number of factors. Since pragmatist design allows for the easy implementation of both qualitative and quantitative data, it 5
will be most suitable for addressing the issue of exchange rates as it allows for the usage of a broad range of research methods (Liavari and Venable, 2009).
Primary data, will be gathered and implemented throughout the thesis in order to provide the arguments with a solid background, based on primary research. The data will be gathered by examining official statistics, administration papers and will be summarized within the text. The use 10
of secondary data will provide a supplementary information, needed to examine the validity of the proposed hypotheses. Examining suitable secondary data and analysing it through a pragmatic approach can lead to better results in regards to the research (Cole et al., 2005). The overall rationale of the thesis will be presenting a theoretical framework and argument based on established academic debates, and then testing them against case studies via a comparative approach in order 15
to examine whether the hypotheses hold up.
The thesis will begin by examining the different options that developing countries have in respect of exchange rates. Section 1 and section 2 have so far provided a short introduction into the topic, outlining both the hypotheses made and the methodology used in the presentation. Section 3 will focus on the types of exchange rates and their implications for developing countries. Examining 20
these will help in understanding why developing countries are reluctant to let their currency float on the financial markets and therefore analysing these is crucial for the overall purpose of the thesis as it explains the specific benefits and limitations of the various types of exchange rate regimes. This will allow for the thesis to defend the hypotheses made earlier based on the theoretical grounds of these exchange rates. Although this section will focus mostly on economic theories, these are 25
P a g e 13 | 104 country prior to a currency crisis. Section 5 will focus on examining the fear of floating behaviour and its implications for developing countries. The thesis will provide the theoretical rationale of this specific behaviour in regards to monetary policy by examining the political and economic effects of currency devaluations. Furthermore, this section will examine the reasons why governments have been behaving in this certain way. As such section 5 is crucial to the overall 5
structure of the thesis as it provides the necessary theoretical justification and explanation for Hypothesis 1 and Hypothesis 2. Section 6 will examine on the three models of currency crises that have been identified in academic literature. While this does not address the hypotheses directly, this theoretical framework will be useful in explaining the events in the case studies. In addition, this section will explain that the development of currency crises is usually preceded by a banking 10
collapse, which means that such event can have significant implications for the political economic system of a particular country. Section 7 will examine the events of the Asian financial crisis and its impact on the de facto and de jure exchange rate policies in four Asian countries. This section will specifically address Hypothesis 1 and will address the issue of ex-post and ex-ante regimes. Section 8 will also examine the preferred choice of monetary policy in regards to interest groups, 15
and authoritarian and democratic political regimes. This analysis will be done based on an institutionalist analysis of specific political systems and the characteristics of the exchange rate regimes, outlined in section 3. Finally, the thesis will test Hypotheses 2 and 3 in section 9 by applying the theoretical framework provided earlier to two case studies, namely Malaysia and Thailand, just prior and after the crisis. This section will examine the way interest groups have 20
influenced the choice of a regime and will examine whether a correlation exists in regards to the fear of floating behaviour. In addition, the case studies will also examine how the nature of the political system fits into this model.
3. Exchange Rate Regimes
Choosing an exchange rate regime is a key macroeconomic policy and an important choice 25
P a g e 14 | 104 established by both the IMF and by literature. This is to be done due to two main reasons. First, it will be useful in explaining why developing countries choose a certain exchange rate regime over the others. Therefore, a connection can be established between how a currency crisis has influenced the move from one exchange rate to another one, therefore, examining both the pre- and after a crisis in a particular country. Second, a number of researchers have indicated that exchange rate 5
regimes can be identified in two ways: de jure and de facto (Calvo and Reinhart, 2002; Levy-Yeyati and Sturzenergger, 2003). The former is based on the official classification by the IMF and consists of exchange rates that have been declared by governments themselves. This suggests that many countries announce an official exchange rate regime, but then implement an actual exchange rate regime that differs from the official one. Ghosh et al. (2002; 8) points out governments often run 10
an exchange rate that is different from the one that has been officially declared in an attempt to manage inflation. The IMF’s classification has been expanding from the simple ‘floating’ versus ‘fixed’ exchange rate regime that was widely used during the 1970s, to an eight regime classification in 1998 (IMF, 2013). In addition, this analysis can shed light on the three hypotheses made, as it provides clarification on why developing countries might end up implementing an 15
exchange rate regime, which is different from the one that is initially announced.
3.1 Fixed Exchange Rate Regimes
A fixed exchange rate regime is one in which the price of the currency is predetermined and the central bank is acting as a market agent, ensuring price stability by stepping in to manage the balance between demand and supply for the currency. The main advantage of pegged exchange rate 20
regimes is that they offer some control over inflations. Palley (2003; 67) points out that the first major advantage of fixed regimes is “that fixed exchange rates imply reduced uncertainty, and this helps reduce the costs of international trade transactions. The second is that fixed exchange rates act as to the discipline monetary authorities, preventing them from pursuing inflationary policies.“ The logic behind controlling inflation is that it occurs in the case of excessive money supply, in 25
P a g e 15 | 104 suggest that countries adopting a fixed exchange rate suffer from considerably lower inflation than countries with floating exchange rate. Levy-Yeyati and Sturzenegger (2003) also demonstrate this fact, but they also argue that countries with fixed exchange rate regimes also have a lower economic growth. These implications are important for developing countries due to the fact that traditionally they suffer from higher inflation rates and due to the fact that price stability offers them the chance 5
to greatly improve their trade with the country their currency has been anchored to. Furthermore, it seems that pegged arrangements are very suitable to the manufacturing sector of tradable good, as the price stability and the stronger trade relationship cause by the fixing of the real exchange rate serve to stimulate the growth of such industries. Therefore, it can be expected that such industries will prefer more stable monetary arrangements, which under the prism of political institutionalism 10
implies that they will try to influence policy in order to maximize their utility.
However, fixed exchange rates suffer from several crucial disadvantages. First, giving up exchange rate flexibility means forfeiting its use as a shock absorber to external shocks (Palley, 2004). Second, currency pegs can seriously limit the ability to use domestic monetary policy in order to stabilize the economy, in the case of high capital volatility. “Abstracting from capital flows, 15
countries with trade surpluses will experience an excess demand for their currencies, while countries with trade deficits will experience an excess supply of their currencies (Palley, 2004; 68).” This has the potential to lead to either a deflationary or expansionary bias due to the change in the money supply. The biggest problems, especially in regards to developing countries, come from the international capital mobility and borrowing in the private sector. Garett (2000) argues that 20
liberalizing the financial markets and establishing a high degree of capital mobility can effectively have a destabilizing effect on a currency peg. This can be explained by the fact that it leaves the peg opened to speculation and herding behaviour. In practice this means that if economic agents perceive that a central bank will not be able to defend the peg, they might start selling the respective currency to avoid financial losses from the expected devaluation (Palley, 2004). The herding 25
P a g e 16 | 104 Considering that the foreign reserves of the central bank are finite, the fact that investors might have capital that exceeds the foreign reserves of a developing country and the minimal loss of transaction costs due to technological advances means that in a world of globalized financial markets, fixed exchange rates can be quite fragile (Setzer, 2006). In addition, fixed exchange rate regimes can cause significant problems when it comes to countries who have been over-borrowing, 5
which are defined by Palley as “a moral hazard, whereby agents think there is no currency risk associated with foreign currency borrowing (Palley, 2003; 69). “ A sudden devaluation or a currency crisis in this case can cause domestic economic actors, who have over borrowed in foreign currency, to end up with a large debt measured in domestic currency, i.e. debt inflation. Keeping in mind all of these implications, it must be explained why developing countries have been adopting 10
fixed exchange rates even after the collapse of the Breton-Woods system. Fixed exchange rate arrangements offer an economic policy tool that can help them in dealing with inflation, establishing stable trade relations with developed countries by pegging the exchange rate to their currency and ensuring price stability. However, the anti-inflation policy and the price stability come at a price that a country with insufficient foreign reserves and low trade balance may be unable to 15
address (Palley, 2003).
3.2 Flexible Exchange Rate Regimes
Theory and empirical analysis point out that fixing the real exchange rate to either another currency, such as the US dollar or a commodity like gold, really does lead to an increase in international trade and investment levels, and disciplines the monetary authority of the country that 20
has adopted it (Broz and Frieden, 2001). However, the problems that are normally identified with pegged regimes have been a source for numerous debates regarding their viability in the field of economics. The alternative has been traditionally identified as undertaking a floating exchange rate regime. The main argument in favour of such a regime has been best described by Milton Friedman (1953) who argues that if domestic prices adjust slowly, it is more “cost effective” to move the 25
P a g e 17 | 104 rates are a better option in the case shocks to the market of goods are more prevalent than shocks to the money markets (Mundell, 1963). This means that countries, which are likely to experience high inflation and high exchange rate volatility due to a combination of political and economic factors are better off pegging their exchange rates. Such implications point out that often developing countries are often a poor candidate for flexible exchange rate arrangements, as this can result in a 5
relatively volatile currency and a weak control over inflation (McDonald, 2007). However, in the case where quick adjustments are needed in the market of goods due to economic shocks, flexible exchange rates are more suitable. However, since developing countries fall in the former category, they are likely to prefer a pegged exchange rate regime.
“Under a full float, demand and supply for domestic currency against foreign
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currency are balanced in the market. There is no obligation or necessity for the central bank to intervene. Therefore, domestic monetary aggregates need not be affected by external flows, and a monetary policy can be pursued without regard to
monetary policy in other countries (Bernhard et al. 2002; 708).”
In other words, in times when capital mobility is of utmost importance to developing countries, 15
floating exchange rate regimes guarantee that governments will able to conduct their own independent monetary policy, which is crucial as it provides an instrument to absorb both internal and external shocks. In addition, it also allows for monetary policy to be set independently in accordance to the domestic context of a given country (Bernhard et al., 2002).
Another advantage of floating exchange rate is that the flexibility it offers can be extremely 20
valuable when inertial inflation, namely the situation in which all prices in the economy are adjusted in regards to a price index with the use of contracts, or rapid capital inflows cause real appreciation, harming the competitiveness and the balance of payments (Edwards and Savastano, 1999). “When residual (or demand) inflation generates an inflation differential between the pegging country and the anchor, it induces a real appreciation that, in the absence of compensating productivity gains, 25
lender-P a g e 18 | 104 of-last resort (McDonald, 2007; 31).” In other word, central banks can finance governments through the increase of the domestic monetary supply or they can bail out banks in times of a crisis.
There are some significant inefficiencies attributed to flexible exchange rate arrangements. The first problem refers to the fact that without a peg, central banks might pursue policies that are in effect inflationary (Hausman, 1999). As such the floating exchange rate regime fails to discipline 5
the monetary authorities and therefore lead to inflation. Kamin (1997) for example clearly shows that higher exchange rate flexibility is related to higher inflation. The problem is most prominent in developing countries, which have been plagued by poor levels of economic development and high inflation. Due to these facts, rapid capital inflows and outflows can lead to a high volatility, which in turn leads to higher inflation. In addition, increasing inadequately the money supply in 10
circulation by the central bank, as well as financing the government’s need by printing money, creates further dangers to price stability (McDonald, 2007). Second, flexible exchange rate regimes have proven to be vulnerable to speculative behaviour on behalf of foreign investors that can lead to a misalignment in the rea; exchange rate (Esaka, 2010). “Misalignment occurs because exchange rates can often spend long periods away from their fundamentals-based equilibrium due to purely 15
speculative influences (McDonald, 2007; 31).” This is what basically happened to the dollar in the beginning of the 80s- sharp appreciation followed by depreciation, which has been attributed largely to speculative behaviour. Third, Hausmann et al. (1999) argues that a crucial problem with flexible and floating exchange rate regimes lies with the so-called peso problem. This issue is associated with lack credibility on financial markets, amongst foreign investors and amongst the public mainly 20
due to decades of economic volatility. Therefore “movements in the nominal exchange rate tend to be anticipated by changes in nominal interest rates, so that real currency rates do not fall (and may in fact rise) in response to adverse shocks (Cardoso and Galal, 2006; 33).”
3.3 The Economic Trilemma and Exchange Rate Regimes
The Economic trilemma has important implications for the choice of an exchange rate
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P a g e 19 | 104 desirable policy objectives. However, it is impossible to achieve all the three and a government must focus on only two of them, depending on their economic situation and their overarching development strategy. In other words, this means that a country choosing to implement the monetary stability, offered by a fixed exchange rate, while retaining its monetary policy independence, must restrict the movement of capital and essentially implement a policy that 5
Aizenman (2010; 3) refers to as “closed financial markets”. This policy framework has been preferred by developing countries in the mid to the late 80s and it represents a form of financial autarky (Aizenman, 2010). On the other hand, under a floating exchange rate regime, governments focus on monetary independence and capital mobility, which has been the preferred choice of the US. Finally, giving up monetary independence means focusing on monetary stability and capital 10
mobility, which is what the European currency union represents (Obstfeld et al., 2004).
Figure 1 – The Impossible Trilemma; Source: Aizenman and Ito (2013)
The problem, however, is that given the amounts of financial interdependence between
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countries and the large levels of capital movements around the globe, the trilemma has become a dilemma as countries seek to attract outside capital under the form of FDI or seek to have better access to foreign capital, through credit (Obstfeld et al., 2004). Essentially, this means that the trade-off is between exchange rate fixity and domestic macroeconomic stability. In case of the former, losing independent monetary policy essentially means giving up a crucial policy tool in 20
P a g e 20 | 104 money and monetary expansion essentially reduces interest rates. Furthermore, the fact that fixed exchange rate regimes are extremely prone to speculative attacks, especially under inconsistent government policy and budget deficits, means that the economy of the country is prone to a recession, if “bad” policy is pursued. Control over inflation and price stability offered by a flexible exchange rate through independent monetary policy often represents an enticing option for 5
developing countries, which traditionally suffer from higher price volatility and inflation, which may in turn put some investors off (Copelovitch, 2012). Therefore, the rationale is that under capital mobility and monetary policy independence, developing countries will be able to attract higher investments.
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A major contribution to this model has been proposed by Mundell (1963), who has analysed
how the trilemma develops in a small country that is supposed to choose its exchange rate regime and the levels of capital mobility. As it is pointed out by Aizenman (2010), this model is rather simplified as it considers only two polarized binary choices in regards to the exchange rate regime, but it illustrates their implications rather well. Under a capital mobility and fixed exchange rate 15
regime, and assuming that foreign government bonds are of equal price with domestic bonds, an increase in the money supply by the central bank will put downward pressure on the domestic interest rates and will trigger the sale of domestic bonds, since investors will seek the higher yield offered by foreign bonds (Obstfeld et al., 2004). Therefore, the central bank will have to intervene in the currency market in order to satisfy the demand for foreign currency, using its reserves to buy 20
the excess supply of domestic currency, which was triggered in the first place by its attempt to increase the monetary supply (Mundell, 1963). “The net effect is that the central bank loses control of the money supply, which passively adjusts to the money demand. Thus, the policy configuration of perfect capital mobility and fixed exchange rate implies giving up monetary policy (Aizenman, 2010; 5).” The implication is that the domestic interest rate is determined and affected by the 25
country to which the currency has been pegged.
A small open economy, that has chosen to forgo a fixed exchange rate and to retain its monetary autonomy, can preserve the mobility of capital. “Under a flexible exchange rate regime, expansion of the domestic money supply reduces the interest rate, resulting in capital outflows in search of the higher foreign yield. The incipient excess demand for foreign currency depreciates 30
P a g e 21 | 104 economy, the interest rate is reduced, which improves domestic investments and reduces the exchange rate of the domestic currency. This in turn increases net exports, but also means that a country loses its exchange rate stability. The problem with this policy is that rapid capital inflows and outflows can destabilize the economy as the loss of exchange rate stability can lead to higher inflation rates. This represents a significant problem for developing countries, which traditionally 5
have suffered from high rates of inflations and therefore monetary stability has been seen as a way to counter this problem (Setzer, 2006). However, in reality countries have experimented with limited capital mobility or various degrees of financial integration, and central banks have been involved in managing the exchange rate in an attempt to reap the benefits of all three of the possible dilemma choices (Aizenman, 2010). Furthermore, the credibility of a fixed exchange rate regime 10
can be in a flux, which means that central banks must actively support it or change under certain external or internal pressures, such as speculative attack. Keeping in mind these implications, it can be argued that the economic trilemma poses an important question regarding the exchange rate regime choice and the overall macroeconomic policy framework of a given country. Furthermore, applying a rational institutionalist analysis to the issue of the economic trilemma, implies that 15
interest groups and social actors will have specific preferences in regards to which two policies are to be pursued by the government and will try to influence the policy-making process in an attempt to maximize their own utility (Cohn, 2012). These policies also have a significant importance when examined under neoliberalism in international relations, as they have a direct impact on how economic interdependence between states is established on the international arena, and in fact each 20
one of the three policies can be perceived as an economic channel through which this interdependence is established.
3.3 Intermediary Exchange Rate Regimes
Real world examples often indicate that a simple two-way distinction is too simplistic and governments have used regimes that do not strictly fall into one of the two categories, which 25
P a g e 22 | 104 1975 and 1998 the IMF has based its classification on two notifications (Diagram 2): 1) official notification by a particular country within 30 days of becoming a member of the IMF and 2) any changes in the rate after that (Bubula and Okter-Robe, 2002). The classification proposed by the IMF has led to four major exchange rate categories, namely pegged regimes, flexible regimes, regimes with limited flexibility and other managed arrangements. Each one of these major 5
categories had a total number of 9 subcategories.
Diagram 2 IMF Exchange Rate Classification - Source: Habermeier et al. (2009)
Based on their finding, Bubula and Okter-Robe (2002) argue that due to the increased capital mobility and the desire to preserve independent monetary policy, countries have sought to 10
adopt more flexible exchange rate regimes, while also achieving a certain amount of exchange rate stability by central bank intervention in the exchange rate. These implications have led to a greater number of de facto exchange rate regimes, which often differ from the ones that have been officially announced, i.e. de jure regimes. Based on their findings they identify twelve actual exchange rates: “exchange rate regimes with another currency as legal tender (dollarization)”; “currency unions”; 15
“currency board arrangements”; “conventional fixed peg arrangements vis-à-vis a single currency”; “conventional fixed peg arrangements vis-à-vis a currency composite”; “forward crawling peg; backward crawling peg”; “pegged exchange rate within a horizontal band”; “forward pegged
P a g e 23 | 104 exchange rate within crawling band”; “backward pegged exchange rate within crawling band”; “tightly managed float”; “other management floating with no predetermined path for the exchange rate; and independently floating” (Diagram 3). Although these can be roughly classified in the three main categories, their sheer number suggests that governments have sought for a way to undertake an exchange rate that combines both of the positive qualities of pegged and flexible exchange rates. 5
The main rationale behind this is attempting to reconcile the impossible trinity under capital mobility, i.e. achieving both exchange rate stability and independent monetary policy. A similar classification is used by Levy and Sturzenegger (2002) who argue that the IMF classification has proven to be incorrect and classify the regimes as flexible, intermediate or fixed. By using a cluster analysis Levy and Sturzenegger (2002) conclude that currencies with high exchange rate volatility 10
and less market intervention are considered floating. On the other hand, a fixed exchange rate is considered to be one where volatility is small but central bank reserves are high. Finally, an intermediate exchange rate can be attributed with moderate volatility and moderate to high exchange rate interventionism by the central bank. In fact, Ghosh and Ostry (2009) argue that growth performance is best achieved under intermediate exchange rate regimes, as they are 15
P a g e 24 | 104 Diagram 3 (Source: Bubula and Okter-Robe 2002; 14)
In order to illustrate best what an intermediary exchange rate is, one can simply examine the notion of a crawling peg. It is generally expected that his regime represents a system of adjustments in which a particular fixed exchange rate regime is allowed to fluctuate within a 5
specific band (Bubula and Okter-Robe, 2002). The bands themselves are also subject to adjustments depending on the targeted inflation, or the inflation differentiations with trading partners. In
De facto Classification of Exchange Rates (Bubula and Okter
Robe 2002)
Intermediate Regimes
Tightly Managed floats
Soft Pegs Crawling bands Backward looking Forward looking Crawling pegs Backward looking Forward looking Conventional fixed pegs Vis-a-vis a single currency
Vis a vis a basket
Hard Pegs Regimes
Currency board arrangement No separate legal Tender Formal dollarization Currency Union Floating Regimes Indepentently floating
P a g e 25 | 104 addition, the rate can either serve as an anchor which is a forward crawling peg or backward crawling peg, when the rate is aimed at “generating inflation adjustment changes (Bubula and Okter-Robe, 2002). This points out to the fact that intermediate exchange rates have been developed as a solution of the impossible trinity (Setzer, 2006). In a world characterized by interconnected world markets, financial institutions and globalized economies, it is crucial to preserve capital 5
mobility, as it offers easy access to FDI, portfolio investments and increases the amounts of investments. Wagner (2000) argues that this is especially true when it comes to the economies of developing countries who seek easy access to foreign capital under the form of loans or to FDI. According to him, however, developing countries benefit from capital mobility only if they have reached a certain degree of development. If capital mobility is chosen, then a developing country 10
has to choose between having an independent monetary policy or a stable exchange rate regime. As such the intermediary exchange rate is a way to seek compromise between the two, by both aiming at achieving a stable exchange rate and a limited monetary policy independence (Setzer, 2006). However, these exchange rate regimes suffer from one important problem- according to the Wyplozs (1998) these currencies are extremely vulnerable to the second generation currency crises 15
models, namely investors are not sure about the government’s commitment to a peg. Therefore, even though a full equilibrium may exist in the form of a consistent policy towards to exchange rate commitment, speculative attacks might occur due to the inability of private financial actors to determine the level of commitment of the government to a peg. In addition, Krugman (1999) maintains that finding such a compromise might be difficult simply because of the fact that the 20
impossible economic trinity obstructs it.
4. Exchange Rate Regime Choice Theories and
Developing Countries
Having outlined the characteristics of the various exchange rate regimes is it important to briefly outline what are their implications for developing countries. Each of these regimes have 25
P a g e 26 | 104 inappropriate policy is pursued. International investors who are suspicious of the ability of a country to defend the peg can launch a speculative attack which might result in a forced devaluation (MacDonald, 2007). Flexible exchange rates on the other hand do not suffer from that problem and they are easily reconciled with the idea of capital mobility (Cardoso and Galal, 2006). Considering the fact that most emerging markets seek to attract capital and FDI in order to fuel their development 5
it can be logical to assume that flexible exchange rates are better suited to the context of capital mobility. However, the implications of floating exchange rates for developing countries have been considered to be severe (Setzer, 2006). This can be attributed to several reasons, the first one being that developing countries suffer from relatively high inflation. Therefore, governments in such countries are eager to establish a system that stabilizes this aspect of the economy (Poirson, 2001). 10
In addition, keeping a relatively devalued currency can help in maintaining a relative amount of competitiveness, especially if the country seeks to develop its export sector. Another problem of developing countries is the fact that their political and governance systems are often perceived to be inadequate, and as such large currency fluctuations on financial markets can be expected (Broz
and Frieden, 2001).The following sections will examine a few core theories that have described
15
how a country chooses its exchange rate. This will help to explain the rationale behind the choice of exchange rate regimes implemented by developing countries and will be useful in analysing the exchange rate regimes in a post crisis scenario.
4.1 Mundell-Fleming Framework
A crucial theory that deals with the economic trilemma and exchange rate regimes under a 20
full capital mobility is Mundell-Flemming Framework (Fleming, 1962; Mundell, 1963). In effect, the theory focuses on the nature of the shocks that the economy faces. According to Poole (1970) there are two types of shocks that can predetermine the best optimal currency choice- nominal shocks, which mainly originate in the domestic financial and monetary system, and real shocks, that begin in the goods market. The exchange rate regime choice depends on which types of shocks 25
P a g e 27 | 104 Poole (1970) allowing the nominal exchange rate to fluctuate can serve as an adjustment mechanism in order to create the needed international price changes, unlike fixed exchange rates.
Furthermore, the Mundell-Flemming framework follows the Keynesian tradition, in which aggregate supply takes the passive role of fixing the price level, while variations in aggregate demand is what determines the level of economic activity (Copeland, 2005). The model examines 5
the relationship between economic output and the nominal exchange rate in an open economy in the short run. The framework has been used as an argument to support the impossible trilemma, in 1which a government cannot simultaneously maintain exchange rate stability, independent monetary policy and free capital movement (Young et al., 2004). The Mundell-Fleming model provides an analysis of small open economies under a fixed or floating exchange rate. In the latter 10
case, an increase of government spending will drive the IS (investment-savings curve, of which government spending is a part) upwards, which will increase the exchange rate, hurt exports and diminish the effect of the government spending (Graph 1) (Copeland, 2005). On the other hand, an increase in the monetary supply will drive the LM (liquidity-money supply curve) right, which results in a lower exchange rate and higher economic output (Graph 2). Under a fixed exchange 15
rate regime, however, the increased government spending will raise the IS curve upwards, which will potentially increase the real exchange rate. Therefore, the central bank must increase the monetary supply in order to keep the peg (Graph 3). However, under a fixed peg, the central bank is unable to do conduct an independent monetary policy, as any increase of the money supply may result in a collapse of the exchange rate regime.
P a g e 28 | 104 Graph 1; Source: Sanders (2008; 2) Mundell Fleming
Framework: Increase in government spending- Floating Exchange Rate Regime
Graph 2; Source: Sanders (2008;3) Mundell Fleming 5
Framework : Increase in Monetary Supply- Floating Exchange Rate Regime
Graph 3; Source: Sanders (2008; 4) Mundell-Fleming Framework: Increase in Monetary Supply under a 10
fixed Exchange Rate Regime
P a g e 29 | 104 monetary authority is to sell foreign exchange when there is an exogenous fall in the money demand. “The sale in reserves, unless sterilized, leads directly to a corresponding change in high-powered money in circulation, which compensates for the shift in money demand, thereby insulating the domestic economy from the original shock (Setzer, 2006; 16).” Finally, according to the Mundell-Flemming approach an intermediate exchange rate regime is suitable for countries that are facing both types of shocks.
4.3 Bi-polar Hypothesis/Hollow Middle Theory
The main argument of the bi-polar hypothesis is that highly managed or intermediatery exchange rate regimes are made susceptible to rapid devaluations due to the rising mobility of international capital flows. Eichengreen (1994) argues that in a world of fully integrated global capital markets only two extremes will remain: free float and “hard peg”. This theory arose in light of the European currency crisis of 1992-93 during which the European exchange rate mechanisms permitted European currencies to fluctuate within a certain limit. However, while the band was widened so that France can stay in the Eurozone, the UK and Italy faced significant speculative pressure and were forced to devalue their currencies (Eichengreen, 1994). These developments have led many economists to suggest that only the two extremes are a viable option under capital mobility.
P a g e 30 | 104 suggests that the government of developing countries will announce a more flexible regime, while maintaining a more managed one.
A final point worth mentioning in regards to the bi-polar hypothesis is the fact that it operates exclusively under the assumption that mobile capital is present. However, a government facing the possibility of a currency or financial crisis may impose prudential capital control in an “ex ante” manner, i.e. as a response policy to the possibility of a crisis before or after it has occurred (Korinek, 2011). Implementing capital controls means that a government can essentially soften the effect of capital outflows before the collapse has occurred. Korinek (2011) argues that the partial implementation of such controls can address capital outflows and portfolio investments, without restricting the inflow of FDI. However, investors may still perceive this as a risk, which may in fact end up reducing FDI flows, on which developing countries are reliant. On the other hand, capital controls can allow the government to use monetary policy to stabilize the exchange rate regime or soften up its eventual devaluation (Korinek, 2011). This will also have considerable implications for the MF model discussed earlier, as under a form of capital control an increase in government spending or an increase in the supply of money may not result in appreciation or depreciation of the real exchange rate respectively. Since in all instances, developing countries suffering from a currency crisis have implemented capital controls during and after the crisis in order to prevent further depreciation and capital outflows, pursuing monetary policy will be a viable strategy when
it comes to stabilizing the exchange rate regime (Kaplan and Rodrik, 2011).
4.4 Exchange Rate Regime Choice for Developing Countries-
Towards an Institutionalist Approach
Considering the theories examined in this section, it can be safely argued that a certain
P a g e 31 | 104 well established financial sector. The main reason behind this is that such countries already have achieved good credibility and under a full capital mobility, it is important for them to preserve monetary independence as a policy tool, as described by the Economic Trilemma. On the other hand, countries which are integrated into a larger neighbouring country or country that have traditionally been suffering from high monetary disorder, low credibility of political and governmental authority and have a large inflation rate are most suited to hard pegs (Yagci, 2001). This way a stable monetary anchor can be established that has a better chance to attract investment and raise the trust in the domestic economy. “The soft peg regimes would be best for countries with limited links to international capital markets, less diversified production and exports, and shallow financial markets, as well as countries suffering from high and protracted inflation under an exchange rate-based stabilization program (Yagci, 2001; 7)”. Yagci (2001) argues that developing countries are the ones that are best suited to this exchange rate regime, since they offer monetary stability and reduce transaction costs. Finally, intermediate regimes are best suited to developing countries with relatively stronger financial sector and have been attributed to disciplined macroeconomic policy.
P a g e 32 | 104 variables, such as the stability and quality of institutional arrangements, do play a role in the policy process of choosing an exchange rate regime.
P a g e 33 | 104
5. Fear of Floating
5.1 Currency Devaluation
Currency devaluation in the real exchange of a country can potentially improve the current account balance by improving the trade deficit. The lower value of the currency encourages exports and reduces imports and therefore improves the country’s trade imbalances (Setzer, 2006). The main assumption is that a devaluation would improve trade balance in the long term, help in dealing with payment difficulties, stimulate demand for export and create employment (Acar, 2000). Since devaluation would lead to smaller demand for imported goods and larger demand for exports, this would lead to an improved balance of payments. However, devaluation, which is a result of a speculative attack, can have contractionary effects and lead to political instability.
5.2 Economic Effects of Devaluations
P a g e 35 | 104 Graph 4. J- Curve Effect; Source: Krugman and Taylor (1978)
Setzer (2006) suggests that devaluation is specifically damaging to the economies of developing countries. Although devaluation can have a positive expenditure-switching effect by increasing the relative cost of imported goods and making domestic output more competitive, thereby lowering imports and stimulating the demand for exports and non-tradable goods, the short term effects of the devaluation can have a damaging effect on the economy (Acar, 2000). This fact is especially true for developing countries who suffer from underdeveloped capital markets, high levels of corruption and lower economic output (Edwards, 1989). Edwards (1989) argues that devaluation in these countries and the increased price of imports is passed quickly on the consumers and the higher demand of export lag behind due to the underdeveloped markets of developing countries. The damage caused by sudden devaluations, however, can have significant impact on the domestic political system, as it can produce large degrees of political instability due to the government’s inability to deal with the initial economic shock.
5.3 Political Implications of Devaluations
P a g e 36 | 104 political backlash by economic agents and the wider public. The second motivation for policymakers to defend a currency peg derives directly from the short-term negative effect of devaluation on both the current account balance and trade balance (Frankel, 2004). “Due to extensive periods of macroeconomic instability and several failed stabilization efforts, the currencies of emerging market economies generally suffer from a lack of credibility (Setzer, 2006; 26)”. Firms and household in developing countries find it extremely difficult to borrow on other markets in their own currency. In addition, foreign investors have distrust in the credibility of the devalued currency, and as such they are unlikely to buy long positions in assets denominated in these currencies, which can result in a capital outflow out of the country that has experienced the devaluation (Remmer, 1991; 779). As such, perception lags play an important part in the development of rapid devaluation, as the exchange rate ultimately depends on a large amount of both external (investors, financial institutions, speculators) and domestic (interest groups, industries, governments) actors.
Therefore, if firms have current investment project they have two choices: to either borrow on the domestic market in their own currency as a form of short term loans, creating a maturity inconsistency, and transaction risks between liabilities and assets or borrowing in a foreign currency, creating a currency mismatch on their balance sheets, since profits are denominated in local currency (Remmer, 1991). The public sector also suffers from these developments, which is born out of low creditworthiness, as investors are more and more unlikely to provide loans to developing countries in their own currencies or to make long-term commitments in hard currencies. This represents a significant problem for those developing countries, the debt of which is denominated in foreign currency. In this instance, a devaluation increases the cost of debt servicing and leads an increased burden on the domestic economy. Such implications logically point to the fact the governments and political institutions would be reluctant to bear the cost of devaluation. As Remmer (1991; 779) points out, these events signalize that the economic policy conducted by the government will be perceived as a failure. This means that the political authorities can lose both political and economic credibility, and as a result of that they can face severe social discontent and potential fall from power.
P a g e 37 | 104 (1994) politically unstable countries are more likely to be impacted by the economic disturbances caused by devaluation, especially if the political authorities have promised to defend the peg. This means that the devaluation will lead to a loss of credibility that can significantly hurt the position of the country on the international financial markets. Setzer (2006) points out that if an economic disequilibrium occurs, the authorities will face retribution from the electorate even if the country recovers relatively quickly after the devaluation. In fact, voluntary devaluations are more likely to occur after a new leader has been elected, as they require a lot of political capital and therefore represent a risk that can be taken by newly elected governments (Edwards 1994). In addition, there is a certain degree of difficulty to estimate what the reaction of the private sector will be. Since different industrial interest groups hold different amount of power and have different interests in regards to the exchange rate regime, a devaluation may mobilize these actors in different ways thus changing the political dynamics within the country.
P a g e 38 | 104 authorities to take advantage of the fluctuations in major currencies to camouflage an effective depreciation of their exchange rate, therefore avoiding the political repercussions of an announced devaluation (Aghevli et al., 1991: 3)". The political and economic implications caused by a rapid devaluation, fits within the traditional rational institutionalist framework. Under this model, social actors and interest groups are utility maximizers and the government is both an agent and a principle, as it is pursuing a specific monetary policy on behalf of other actors, while it is interested in exchange rate regime stability due to its interest in its own survival. A rapid devaluation will thus undermine the confidence in the government as a principle actor and will thus destabilize it, as other social actors will perceive their utility as diminished. Therefore, it can be expected that economic and political actors will put significant pressure on the government in a post-devaluation scenario.
5.4 Fear of Floating
Considering the political and economic costs of devaluation, it can be easily argued that governments in developing countries will try to prevent devaluations. Taking into account the dangers of low monetary and fiscal discipline, poorly developed institutions and high sensitivity to capital inflows and outflow, it can be assumed developing countries will be reluctant to let their currencies float on the financial markets as governments will fear that this may result in high inflation. In fact, as argued by Setzer (2006), poor governance and political instability can lead to a reduction in the demand for domestic currency and thus lower investments. Such an effect has been well documented by Calvo and Reinhart (2000) who have examined the exchange rate behaviour of thirty-nine countries over the period of 1970- 1999 and have discovered that developing countries have been reluctant to leave their currencies to float. This effect has become known in literature as “fear of floating” but as Calvo and Reinhart (2002) argue this effect is part of a larger phenomenon, best described as “fear of currency swings”.
