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 Address: 73 Hawthorn Way, Cambridge, United Kingdom Mobile Number: 07764976154
The Political Economy of Exchange Rate Regimes in Developing Countries
DECLARAION BY CANDIDATE
I hereby declare that this thesis, “International Political Economy and Exchange Rate Regimes in Developing 5
Countries: Exchange Rate Regime Choice in Post-Crisis Environment”, is my own work and my own effort 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.
Name: Martin Belchev 10
Date: 20.12.2015
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The Political Economy of Exchange Rate Regimes in Developing Countries
Content 5
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 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
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4.
Exchange Rate Regime Choice Theories and Developing Countries................................................... 25 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 15
5.1 Currency Devaluation ........................................................................................................................ 33 5.2 Economic Effects of Devaluations ...................................................................................................... 33 5.3 Political Implications of Devaluations ............................................................................................... 35 5.4 Fear of Floating ................................................................................................................................. 38 6.
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Currency Crises and their implications for Developing Countries ....................................................... 40 6.2 First Generation Model of Currency Crises....................................................................................... 40 6.3 Second Generation Crisis Model ........................................................................................................ 42 6.3 Third Generation Model ..................................................................................................................... 44 a.
7. 25
Twin Crises.................................................................................................................................. 45
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 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 30
8.1 Interest Groups in Favor of Fixed Exchange Rates ........................................................................... 58 8. 2 Interest Groups in Favor of Flexible Exchange Rate Regimes ......................................................... 59 8.3 Authoritarian Vs Democratic Regimes ............................................................................................... 61 a.
Authoritarian 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. 5
Case Study: Thailand and Malaysia ..................................................................................................... 67 9.1 Case Study: Introduction .................................................................................................................... 67 9.2 Thailand and the Asian Crisis of 1997 ............................................................................................... 68
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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 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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The Political Economy of Exchange Rate Regimes in Developing Countries
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 5
correlated with the way developing states are integrated on the international arena and thus this 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
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choice adopted by developing countries in a post-crisis environment. The research has employed a 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
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respective governments and essentially influence the choice of an exchange rate regime. Finally, 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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Running Title: The Political Economy of Exchange Rate Regimes in Developing Countries
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The Political Economy of Exchange Rate Regimes in Developing Countries
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 5
undertake, as it forms a crucial set of policy tools and institutional arrangements through which a 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
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policy and that can influence the overall economic performance through numerous channels such 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
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component of East Asian countries’ rapid economic growth over the past several decades (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
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century with the attempt to structure and organise monetary policy by implementing a “classical” 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
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new period of stability and “presided over the greatest boom in the history of global capitalism (Kettel, 2004: 5)”. Consequently, it can be concluded that the choice of an exchange rate regime has serious implications for the international relations and for the international political economy. Having an impact on issues such as development, trade and even supranational organisations, such P a g e 5 | 104
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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). 5
Increased capital volatility and liberalization, however, put serious pressure on the 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
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aversion and changes in the perceived risk of investing in certain currencies (Kohler, 2010; 39)”. 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
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preceded by banking sector collapses and problems, following the aftermath of financial 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.
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A collapse of an exchange rate regime implies that a given country will have to adopt more 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
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what economists refer to as a de jure exchange rate regime, or the one officially announced, and de facto exchange rate regime, the one actually pursued by the government of a given country (LeBlang, 2003). While the research, which has analyzed this behaviour in non-crisis times is plenty, there has been little research on how and why developing countries choose a specific exchange rate regime in a post-crisis scenario. Furthermore, most models discussing he exchange
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rate regime choice usually focus on non-crisis episodes (Setzer 2006). Setzer (2006) argues that P a g e 6 | 104
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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 5
exchange rate regime (IMF, 2003). The main argument of the hypothesis is that due to the increased 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
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regime has been the institutional and historical characteristics of the state (Edwards, 1996; Poirson, 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
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international relations and international political economy, as it encompasses the utilitymaximizing 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,
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institutions are established and continuously reformed, as they fulfil certain functions for these 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
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lower transaction costs (Pierre et al., 2008). In other words, institutions serve to provide policy channels, through which various actors influence policy to maximize their own utility. Institutional arrangements, political processes and social actors can have a considerable amount of influence over the choice of an exchange rate regime (Frieden 2014). This can be attributed to the fact that economic and political actors will seek to maximize their own interests through monetary policy.
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Furthermore, as Broz and Freden (2001) argue, the political regime and the quality of the P a g e 7 | 104
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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 5
alternative for analysing exchange rate regime choice in a post crisis environment, as it provides an 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
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issue. 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,
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1985). However, the traditional neoliberal framework focuses on the notion that states establish 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
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exchange rate regimes, even though international regimes have been established in the past, when 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
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framework, which would explain how exchange rate regimes are determined, as it fails to take in account domestic pressure. Furthermore, given the impact of exchange rate regimes on the domestic economy of a given state and their implications for the relations between states, especially when considering the issues of economic interdependence, trade and development, has an impact on the way states interact on the international arena (Cohn, 2012).
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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 5
analytical framework, which can explain how the choice of exchange rate regimes are influenced 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
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government has a distinctive authoritarian character, and thus this will allow the research to uncover 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
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that the choice of an exchange rate regime in developing countries in a post-crisis is dependent on 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
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relations theories, in order to expand upon existing literature on the subject, address existing 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 25
prospects invite large capital flows leading to over-borrowing and unsustainable asset price booms 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
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making process in regards to the choice exchange rate regime in a post-crisis environment. P a g e 9 | 104
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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 5
behavior as a fear of floating and it represents the reluctance of countries, and their respective 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
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currency. 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
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utility maximizers. 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
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not need to depoliticize the issue. The second factor can be attributed to the lack of transparency and stability, which such regimes try to overcome by using a peg. Therefore, specific institutional arrangements in democratic countries and authoritarian regimes will influence the choice of exchange rate regimes in a post-crisis scenario.
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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 5
proposed hypothesis, and will examine data and theories by scholars, academics and professionals 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
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qualitative data is suitable in examining the validity of already grounded theories and employing 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
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philosophy, but rather employs a mixed method approach to the research objectives in order to examine the proposed problem in the most suitable and exhaustive way. By applying this research design to the thesis, a certain amount of flexibility will be achieved, thus addressing the research P a g e 11 | 104
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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 5
pragmatist design allows for the easy implementation of both qualitative and quantitative data, it 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
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examining official statistics, administration papers and will be summarized within the text. The use 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
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academic debates, and then testing them against case studies via a comparative approach in order 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
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will focus on the types of exchange rates and their implications for developing countries. Examining 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
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of these exchange rates. Although this section will focus mostly on economic theories, these are important as they will provide a strong theoretical basis upon which the post-crisis exchange rate regime will be examined. Section 4 will focus on the most prominent exchange rate choice theories. Much like the previous sections, the aim of this section is to provide an economic rationale for choosing a specific exchange rate and their implications for developing countries. As it will be
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shown in the case studies, these theories can explain the choice of an exchange rate by a developing P a g e 12 | 104
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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 5
governments have been behaving in this certain way. As such section 5 is crucial to the overall 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
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section will explain that the development of currency crises is usually preceded by a banking 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.
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Section 8 will also examine the preferred choice of monetary policy in regards to interest groups, 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
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Thailand, just prior and after the crisis. This section will examine the way interest groups have 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 25
Choosing an exchange rate regime is a key macroeconomic policy and an important choice for governments, regardless of the level of development of their respective states. Developing countries use this policy tool as a way to manage their trade balance, achieve price stability and even attract capital, which will be further elaborated in this section (Levy-Yeyati and Sturzenergger, 2003). This aim of this section is to classify the various exchange rates in a way that has been P a g e 13 | 104
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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 5
crisis in a particular country. Second, a number of researchers have indicated that exchange rate 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
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regime that differs from the official one. Ghosh et al. (2002; 8) points out governments often run 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
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made, as it provides clarification on why developing countries might end up implementing an 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 20
balance between demand and supply for the currency. The main advantage of pegged exchange rate 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.“
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The logic behind controlling inflation is that it occurs in the case of excessive money supply, in which the central bank can intervene and use its foreign reserve the control it. This mechanism also ensures that the central bank will react in case of an investor flight to a currency with higher purchasing power, thus preventing possible devaluations. Ghosh (1997) seems to confirm these findings in a research conducted in 135 countries in the period of 1960-1989, the results of which P a g e 14 | 104
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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 5
they suffer from higher inflation rates and due to the fact that price stability offers them the chance 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
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will prefer more stable monetary arrangements, which under the prism of political institutionalism 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
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order to stabilize the economy, in the case of high capital volatility. “Abstracting from capital flows, 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
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international capital mobility and borrowing in the private sector. Garett (2000) argues that 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
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currency to avoid financial losses from the expected devaluation (Palley, 2004). The herding scenario can occur if other investors are alarmed by this and join in selling this currency, without the necessary knowledge on whether the peg is actually going to hold. This can also be fuelled by speculation undertaken by investors who suspect that the fixed regime might not hold (Krugman, 1979).
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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 5
regimes can cause significant problems when it comes to countries who have been over-borrowing, 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
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mind all of these implications, it must be explained why developing countries have been adopting 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
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at a price that a country with insufficient foreign reserves and low trade balance may be unable to 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 20
international trade and investment levels, and disciplines the monetary authority of the country that 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
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(1953) who argues that if domestic prices adjust slowly, it is more “cost effective” to move the nominal exchange rate as an answer to a shock that requires an adjustment in the real exchange rate. “For example, a fall in demand in the rest of the world for the home country’s exports would automatically be countered by an exchange rate depreciation and a fall in the terms of trade, which produced an offsetting stimulus to demand (McDonald, 2007; 30).” In addition, flexible exchange P a g e 16 | 104
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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 5
countries are often a poor candidate for flexible exchange rate arrangements, as this can result in a 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.
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“Under a full float, demand and supply for domestic currency against foreign 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).”
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In other words, in times when capital mobility is of utmost importance to developing countries, 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).
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Another advantage of floating exchange rate is that the flexibility it offers can be extremely 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
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the anchor, it induces a real appreciation that, in the absence of compensating productivity gains, leads to balance-of-payments problem (Broz and Frieden, 2001; 333).” An exchange rate that is flexible can be used by policy makers to adjust the exchange rate according to these external and internal shocks. Floating exchange rate regime also “allows the central bank to maintain two potentially important advantages of an independent central bank, namely, seigniorage and lenderP a g e 17 | 104
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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 5
in effect inflationary (Hausman, 1999). As such the floating exchange rate regime fails to discipline 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,
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which in turn leads to higher inflation. In addition, increasing inadequately the money supply in 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
15
rates can often spend long periods away from their fundamentals-based equilibrium due to purely 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
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with lack credibility on financial markets, amongst foreign investors and amongst the public mainly 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 25
The Economic trilemma has important implications for the choice of an exchange rate regime. The trilemma basically states that a country may choose only two of the three policies, namely monetary independence (the ability to change interest rates as a response to exogenous shocks or domestic shocks), exchange rate stability and financial integration (capital mobility). The trilemma is illustrated in the triangle in Figure 1 and each one of the sides of the figure represents P a g e 18 | 104
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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 5
independence, must restrict the movement of capital and essentially implement a policy that 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
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US. Finally, giving up monetary independence means focusing on monetary stability and capital mobility, which is what the European currency union represents (Obstfeld et al., 2004).
Figure 1 – The Impossible Trilemma; Source: Aizenman and Ito (2013)
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The problem, however, is that given the amounts of financial interdependence between 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
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former, losing independent monetary policy essentially means giving up a crucial policy tool in dealing with recessions, which operates on the idea that the central bank can manage the supply of P a g e 19 | 104
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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 5
exchange rate through independent monetary policy often represents an enticing option for 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, 15
but it illustrates their implications rather well. Under a capital mobility and fixed exchange rate 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
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in the currency market in order to satisfy the demand for foreign currency, using its reserves to buy 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,
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2010; 5).” The implication is that the domestic interest rate is determined and affected by the 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
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search of the higher foreign yield. The incipient excess demand for foreign currency depreciates the exchange rate (Aizenman, 2010; 4).” If a higher supply of money is introduced into the P a g e 20 | 104
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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 5
inflation rates. This represents a significant problem for developing countries, which traditionally 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
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dilemma choices (Aizenman, 2010). Furthermore, the credibility of a fixed exchange rate regime 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,
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applying a rational institutionalist analysis to the issue of the economic trilemma, implies that 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
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economic interdependence between states is established on the international arena, and in fact each 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 25
governments have used regimes that do not strictly fall into one of the two categories, which essentially represents an attempt to resolve the impossible trilemma by adopting a certain amount of flexibility and stability when it comes to an exchange rate regime policy (Bubula and OkterRobe, 2002). In this regard, a study conducted by Bubula and Okter-Robe (2002) discovered that the IMF classifications do not reveal the full picture in regards do exchange rate regimes. Between P a g e 21 | 104
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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, 5
regimes with limited flexibility and other managed arrangements. Each one of these major categories had a total number of 9 subcategories. Arrangements with no separate legal tender
Hard Pegs
Currency board arrangements
Pegged exchange rate with horizontal bands
1998 IMF De Facto Exchange rate classification
Intermediate pegs
Crawling peg
Conventional fixed peg
Crawling band
Soft Pegs
Floating Arrangements
Managed floating Indepently floating
Other Managed arrangements
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 10
capital mobility and the desire to preserve independent monetary policy, countries have sought to 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:
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“exchange rate regimes with another currency as legal tender (dollarization)”; “currency unions”; “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 22 | 104
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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 5
an exchange rate that combines both of the positive qualities of pegged and flexible exchange rates. 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
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analysis Levy and Sturzenegger (2002) conclude that currencies with high exchange rate volatility 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
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growth performance is best achieved under intermediate exchange rate regimes, as they are associated with lower nominal and real exchange rate volatility, allow for greater trade openness and are associated with lower inflation, while offering some degree of flexibility. This can explain why developing countries have favoured intermediately exchange rate regimes as their de facto monetary arrangements.
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Tightly Managed floats
Backward looking
Forward looking
Crawling bands
Backward looking
Intermediate Regimes
Soft Pegs
Crawling pegs
Forward looking
Vis-a-vis a single currency Conventional fixed pegs
De facto Classification of Exchange Rates (Bubula and Okter Robe 2002)
Vis a vis a basket
Currency board arrangement
Formal dollarization
No separate legal Tender
Currency Union
Hard Pegs Regimes
Indepentently floating
Floating Regimes
Other managed float with no predermined exchange rate path
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 5
adjustments in which a particular fixed exchange rate regime is allowed to fluctuate within a 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 P a g e 24 | 104
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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 5
world markets, financial institutions and globalized economies, it is crucial to preserve capital 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
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reached a certain degree of development. If capital mobility is chosen, then a developing country 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
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Wyplozs (1998) these currencies are extremely vulnerable to the second generation currency crises 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)
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maintains that finding such a compromise might be difficult simply because of the fact that the 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 25
briefly outline what are their implications for developing countries. Each of these regimes have important implications for developing countries. Based on these findings, several conclusions can be made. For example, returning back to the fixed exchange rates it is relatively easy to argue that increased capital mobility can significantly damage the ability of governments to defend the peg if P a g e 25 | 104
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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 5
the fact that most emerging markets seek to attract capital and FDI in order to fuel their development 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
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countries are eager to establish a system that stabilizes this aspect of the economy (Poirson, 2001). 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
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and Frieden, 2001). The following sections will examine a few core theories that have described 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 20
A crucial theory that deals with the economic trilemma and exchange rate regimes under a 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,
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that begin in the goods market. The exchange rate regime choice depends on which types of shocks are more prevalent. If real shocks occur more frequently and are predominant on the domestic market the framework recommends employing floating regimes. “The logic behind this finding is that real shocks require a change in the relative prices to restore competitiveness (or to reduce inflationary pressure) in case of a negative (positive) real shock (Setzer, 2006; 16).” According to P a g e 26 | 104
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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 5
demand is what determines the level of economic activity (Copeland, 2005). The model examines 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
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provides an analysis of small open economies under a fixed or floating exchange rate. In the latter 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
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results in a lower exchange rate and higher economic output (Graph 2). Under a fixed exchange 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
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result in a collapse of the exchange rate regime.
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Graph 1; Source: Sanders (2008; 2) Mundell Fleming
5 Graph 2; Source: Sanders (2008;3) Mundell Fleming
Framework: Increase in government spending-
Framework : Increase in Monetary Supply- Floating
Floating Exchange Rate Regime
Exchange Rate Regime
Graph 3; Source: Sanders (2008; 4) Mundell-Fleming
10 Framework: Increase in Monetary Supply under a fixed Exchange Rate Regime
These arguments have a profound effect on the choice of an exchange rate regime and show that under complete capital mobility and fixed exchange rate regimes, a country must forgo its monetary policy independence. A fixed exchange rate should then be chosen if the nominal shocks on the domestic economy are a prevalent source of economic disturbances. This ties with the economic trilemma and explains why in under mobile capital, a government must make one of two important choices- a stable exchange rate regime or independent monetary policy. This means that a country which suffers from a high-inflation rate and exchange rate volatility is better suited to choose a fixed exchange rate. Under an exchange rate regime that is pegged, the role of the P a g e 28 | 104
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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 highpowered 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. In fact, if the bi-polar hypothesis is true, then the number of hard pegs and free floating currencies should be constantly growing, as countries realize that intermediately exchange rate regimes are not a viable solution to the economic trilemma. Furthermore, proponents of this hypothesis argue that since intermediately exchange rate regime are inherently unstable, then countries which have suffered a currency collapse will be likely to set their exchange rate regime in one of the two extremes (Murray, 2003). It is important to point out, however, that the bi-polar hypothesis has been often criticized for either not being properly tested or failing to take into account that the two extremes are not always the best option for developing countries. “While the major industrialized countries have indicated a marked preference for either strong fixes or free floats, both of these solutions pose serious problems for countries with less-developed financial markets, limited credibility, and rudimentary supervisory systems (Murray, 2003; 25).” If the hollow middle theory is correct, then the first hypothesis made in this thesis will not hold, as it P a g e 29 | 104
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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 CountriesTowards an Institutionalist Approach Considering the theories examined in this section, it can be safely argued that a certain amount of disagreement on how countries choose their exchange rate exists. A rather simple but comprehensive alternative is proposed by Yagci (2001), who argues that floating regimes are best suited to medium and developed countries, and for a few emerging economies, which have a relatively small import and export sector compared to their overall GDP. Yet such countries are well integrated into capital markets and possess a relatively diversified production and trade, and P a g e 30 | 104
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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. Yagci (2001) argues that key determinants to choosing a particular exchange rate regime are government credibility and vulnerability to currency attacks. With the steady increase of international capital flows, the credibility of governments in developing countries has become a more pressing issue, as failure to keep promises of low inflation can have damaging effects on credibility, as investors will be less likely to trust future policy announcements (Yagci, 2001). Difficulties in maintaining credibility under capital mobility and with a pegged exchange rate regime increase the risk of capital outflows and rapid devaluation (Yagci, 2001). Therefore, it can be argued that lack of credibility can lead to a significant increase in terms of currency crisis vulnerability. “These doubts may arise from real or perceived policy mistakes, terms of trade or productivity shocks, weaknesses in the financial sector, large foreign-denominated debt in the balance sheets of a significant part of the economy, or political instability in the country (Yagci, 2001; 8).” Yagci’s (2001) argument has significant implications for developing countries, which face a currency crisis and recent devaluation, in which they are forced to adopt a more flexible exchange rate regime. Yagci’s (2001) arguments point out to a strong relationship between political and economic factors, when it comes to choosing a suitable exchange rate regime. Therefore, P a g e 31 | 104
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variables, such as the stability and quality of institutional arrangements, do play a role in the policy process of choosing an exchange rate regime. Yagci’s (2001) argument fit with the rational institutionalist explanation of policy making and therefore it can be expected that interest groups and political actors try to influence policy in order to meet their own economic and political goals. Since political credibility, inflation and trade play a crucial role in the choice of an exchange rate regime, rational institutionalism argues that social and political actors will try to influence certain policy outcomes in an attempt to maximize their own utility (Pierre et al., 2008). As such, institutions serve to set out the “rules of the game” and create a space for political competition, and as such they can be perceived as a way to diminish transaction costs (Wu, 2009). However, not all social actors have the same power and resources, and as such they will behave under a careful cost-benefit analysis. Furthermore, the behaviour of a given actor is highly dependent on the actions of the others and therefore it can be argued that they are interdependent. A key concept in the rational institutionalist approach is the principal-agent model. Under this model a given actor enters into an agreement with another party and delegates responsibility to it in order to meet its preferences (Frieden, 2014). However, the agent can be enticed in pursuing their own interests due to an asymmetry of information within the system. According to rational institutionalism, the internal political system of a given state is referred to as “structured institutions” (Kettel, 2004). Structured institutions represent formal political and economic arrangement, with clearly defined rules and political system. As such political offices, regulatory agencies or executive roles are either subject of appointment or elections, which makes politicians the agents within the systems. However, since politicians depend on other actors, as they are interdependent, they will likely act in accordance to the “rules of the game” established by institutional arrangements (Pallesen, 2000). Under these assumptions and considering the fact that exchange rates have certain economic implications in terms of their specific pros and cons, it can be expected that political and economic actors will have an impact on the choice of an exchange rate regime. Therefore, under this system, the government will act as both an agent and a principal. Therefore, the quality of the institutions, political instability, inflation and the volume of trade will play a considerable role in the preferences of actors.
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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 A theoretical approach, which has been developed in the mid-70s, argues that currency devaluations can in fact be contractionary especially when it comes to developing countries. Krugman and Taylor (1978) argue that the effect of devaluation on a country that has an initial trade deficit will result in a lower aggregate demand. “Within the home country the value of ‘foreign savings’ goes up ex ante, aggregate demand goes down ex post, and imports fall along with it. The larger the initial deficit, the greater the contractionary outcome (Krugman and Taylor, 1978; 446).” In other words, the value of foreign capital inflows goes up due to the real depreciation of the domestic currency, while the demand for imported goods decreases. This has two major implications: first it worsens the purchasing power of individuals in regards to certain imported goods, which can have a negative impact on the overall domestic demand (Krugman and Taylor, 1978). Second, firms that depend on imported intermediary goods or on importing certain technologies, will face deterioration of their account balance, since the price of imports will increase and their ability to export finished goods will diminish. Furthermore, this will have a damaging effect on national accounts, since the overall price of imports will rise across all sectors and the exports of certain sectors, which depend on imported intermediary goods, will decrease.
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According to Calvin and Reinhart (2000a) devaluations also leads to a redistribution of income from wage earners to profit recipients. “Since profit recipients have a higher marginal propensity to save than wage earners, the distributional effect places an additional contractionary effect on the domestic economy (Setzer, 2006; 25).” Both the decrease in aggregate demand and the income redistribution suggest that a contractionary effect will occur. In fact, according to Krugman and Taylor (1978) even though devaluation can help in the long-term trade balance of a particular country, the well-known J curve effect suggests that the trade balance will actually worsen immediately after the devaluation, which will have a negative impact on both employment and growth (Graph 4). This effect has been explained by the Marshall-Lerner condition and is basically caused by the low import and export elasticities immediately after the depreciation, which results from a failure to recognize the new economic situation (Paul, 2009). These effects depend on the amount of traded items in consumption and the overall levels of trade. Krugman and Taylor (1978) argue that there are two possible outcomes of this. “In the case of price flexibility, total output and employment do not change. The contraction of domestic spending or the decline in absorption is offset one-for-one by improvement in net exports, so the total output remains unchanged (Acar, 2000; 65).” The second one suggests that in the case of price rigidities and reduced economic output, prices will adjust slowly, which means decreased demand and excess supply of goods. As a result, the total output will be reduced if the demand for goods that are nontraded decreases by “more than the rise in net foreign demand for traded goods (Acar, 2000; 62).” However, the first conditions only hold true under full employment. Since the unemployment is usually high in the case of developing countries, this means that the first outcome will be unlikely and therefore, the overall effect of the devaluation will be contractionary.
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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 Rational economic actors would anticipate the long term effects of devaluation that encourage exports and as such they should be hesitant to punish politicians (Frankel, 2004). However, the immediate negative effects such as an increase in unemployment and reduced output suggest that the expectation of economic expansion might not be enough to compensate for this (Frankel, 2004). This means that policy makers are likely to defend the peg in order to avoid P a g e 35 | 104
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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. In this respect, Cooper (1971) has conducted a study which has uncovered that in 24 cases of devaluation, in 7 the governments fell from power in the following year. According to Edwards P a g e 36 | 104
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(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. A model developed by Collins (1996) explains that different political regimes entail different political costs. For example, a currency crisis that leads to the collapse of a pegged exchange rate or the rapid devaluation of a pegged exchange rate regime within a democracy incurs larger political costs as the public, the industry and investors perceive it as a breach of public promise and lack of credibility. Therefore, governments that have employed a pegged exchange rate regime will be reluctant to leave it as they fear that this will lead to loss of political legitimacy and credibility. This has in effect lead to a politicization of the issue. In this respect, Collins (1996) argues that this can explain why there has been a move towards more flexible exchange rates as governments are eager to depoliticize the issue. “Given the risk that the abandonment of a currency peg may cause political turmoil, a more useful strategy for policymakers is to remove the political nature of exchange rate policymaking and keep from pegging the exchange rate (Setzer, 2006; 28).” In addition, under floating regimes, the real exchange rate is easier to manipulate by the central bank, while keeping such actions away from the public’s view and other economic actors. In addition, since the government has not announced a peg, potential devaluations or crises may not be perceived as a shortfall of the particular economic policy pursued by the government and as a result of this the incurring political costs will be minimized (Collins, 1996). Aghevli et al. (1991) this argument and claims that since devaluations under a pegged exchange rate regime is stigmatized by the domestic political system, policymakers can adopt a more flexible regime that they can later fix to an undisclosed basket of currencies. “Such an arrangement enables the P a g e 37 | 104
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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”. Calvo and Reinhart (2002) argue that from the 1980s onwards, a steady move towards more flexible exchange rate regimes has been observed. However, empirical evidence collected by the authors suggests that developing countries have been reluctant to let their currencies float on the financial markets, which can be attributed to the lack of credibility that is manifested through two channels- sovereign credit ratings and volatile interest rates (Calvo and Reinhart, 2002). Therefore, it can be assumed that financial market expectation has an important impact on the exchange rates, P a g e 38 | 104
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capital flows and trade, and as such governments seek to ensure that their economic policy is perceived as credible and stable. Calvo and Reinhart (2000) point out that during periods of growth and full access to foreign capital markets, developing countries will be concerned with retaining credibility and as such they will behave according to the “fear of floating” model. In addition, exchange rate swings and higher inflation are traditionally higher in developing economies than in developed ones, which means that governments, concerned with inflation, are more likely to try to influence the exchange rate regime (Hausmann, 1999) Calvo and Reinhart (2002) argue that this results in a de jure regime (the one that is officially announced) and a de facto regime (the one that is officially being followed by the monetary authority). They argue that this behaviour can be traced by two determinants: exchange rate volatility and reserve volatility. If the former is low and the latter is relatively high, then it can be deduced that a specific country is using its foreign reserves to influence the real exchange rate. However, it must also be pointed out that developing countries are not relying solely on exchange rate regime manipulation but also on monetary policy (Calvo and Reinhart 2000). “The high volatility in both real and nominal interest rates suggests both that countries are not relying exclusively on foreign exchange market intervention to smooth fluctuations in the exchange rates-interest rate defenses are commonplace--and that there are chronic credibility problems (Calvo and Reinhart, 2000; 3).” This supports the argument that the implementation of de facto intermediary exchange rate regimes under capital mobility, combined with monetary policy as an economic tool, has been employed by developing countries as a mean of reconciling the three policy objectives of the impossible trilemma in pre-crisis periods. While the fear of floating hypothesis has been developed as a model describing the behavior of countries in a normal (pre-crisis) period, the thesis will argue that due to a set of political and economic factors, developing countries will behave under this model immediately after a crisisperiod. If Hypothesis 1 is correct, then, it should be expected that developing countries will be reluctant to let their currencies float, even after the collapse and devaluation of their currency. In addition, Calvo and Reinhart (2000) predominantly focus on economic factors in their analysis. However, the political implications of devaluations that were examined earlier suggests that the fear of floating is a result of a mix of factors including political processes, power relations between interest groups and economic development goals. This correlates with the core assumption of P a g e 39 | 104
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institutionalism, as various political actors and economic agents will seek to influence a given policy in an attempt to maximize their utility. As such, they will try to use existing institutional arrangements and political relations between the different actors to influence the de facto choice of an exchange rate regime.
6. Currency Crises and their implications for Developing Countries In economic terms, a currency crisis refers to an episode in which a drastic devaluation of the exchange rate occurs in an extremely short period of time. Furthermore, as pointed out by Cooper (1971) large devaluations are often followed by political instability and change of government. “Being aware of this danger, policymakers in countries with a currency peg often resist devaluing their currency despite large and unsustainable macroeconomic imbalances (Setzer, 2006; 63).” The political and economic effects of devaluations have significant impact on the economic performance of a given state and on the way government deal with the post-crisis exchange rate regime choice. This section will provide an outline of the type of currency crises and will argue that in the current global economy, currency crises are likely to develop simultaneously with a financial crisis.
6.2 First Generation Model of Currency Crises The first model of currency crises was developed by Krugman (1979), who assumes that crises can occur due to the inconsistency in the macroeconomic policies that are implemented to maintain a currency peg. Under this model, all major economic players have complete information on this process and are aware of the condition of the foreign reserves, which the central bank uses to maintain the peg and the government is running a deficit, which the central bank finances by printing money (Miguez- Alfonso, 2007). Individual and private economic actors, however, realize this inconsistency and start trading their domestic currency holdings of foreign currency. This in turn puts downward pressure on the domestic currency and forces the central bank to defend the peg by purchasing the excessive supply. “The model concludes that the peg will be abandoned before the reserves are completely exhausted. At that time, there will be a speculative attack that P a g e 40 | 104
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eliminates the lasting foreign exchange reserves and leads to the abandonment of the fixed exchange rate (Miguez- Alfonso, 2007; 87).” The first model assumes that economic agents are rational and they have complete information over the process. As such, they can correctly foresee the inevitable devaluation caused by the contradictions in policy and will take measures to defend themselves (Krugman, 1979). This in turn will start a speculative attack far before the reserves are actually exhausted. Assuming that the first generation model is correct, a rather curious implication arises- if the information is perfectly known and available, then why are governments reluctant to adjust prior to the speculative attack. In this respect, Setzel (2006; 65) argues: “Political constraints result from the myopic behavior of policymakers. Over expansionary economic policy, e.g., is more likely to happen during election periods (because policymakers have strong incentives to reduce high unemployment rates at these times), when a party with a lower preference for fiscal stability is in office, or when the government is subject to the lobbying of powerful interest groups. Accordingly, the likelihood of a crisis should be highest in these periods.” In other word, the government is reluctant to devalue since it is either motivated by achieving political ends or is under direct political pressure by other actors, regardless of whether they are political or economic. Furthermore, abandoning a peg may be perceived as a broken commitment, which will diminish the credibility of a given government. However, the model has some shortcomings and in this respect Drazen (2000) argues that political authorities do not wait for the foreign reserves to fall under a certain crucial point and that they take a more proactive role in defending the peg, which might be done by raising interest rates. Therefore, the decision whether to leave the peg seems to be dependent on the analysis of the trade-offs between maintaining higher interest rates and losing political credibility, in case of a move to a floating exchange rate regime. However, since in the real world information is often incomplete and asymmetric, developments like these may raise concerns among private economic actors, who might fail to recognize the government’s objective and mount a speculative attack nevertheless (Hefeker, 2000). These findings fit in the ‘fear of floating’ behavior and as it will be argued later have further implications even after the devaluation has already occurred. The implication of the first generation model of P a g e 41 | 104
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currency crisis is clear- its core problem seems to be endemic to fixed exchange rate regimes, i.e. the inability of the central bank to defend the currency against speculators. However, it is important to point out that this model remains largely theoretical and does not explain the most recent and most severe currency crises. In fact, although the model does account for political pressure on governments to maintain the peg, it does not account for the fact that a currency crisis can occur before the government implement inconsistent policies (Eichenbaum and Rebelo, 2001).
6.3 Second Generation Crisis Model The second model of currency crises seeks to explain that currency crises and speculative attacks can occur even while the government policy is consistent with the peg. Under this model, the government and the central bank are not running a deficit and there is no excessive supply of the domestic currency on the financial markets. “Loosely, a second-generation model imagines a government that is physically able to defend a fixed exchange rate indefinitely, say, by raising interest rates, but that may decide the cost of defence is greater than the cost in terms of credibility or political fallout from abandoning the defence and letting the currency float (Krugman, 2000; 4).” In this scenario the currency crisis is most likely to develop because of the fact that economic agents are doubtful about the government’s willingness to defend the peg, which in turn leads the central bank to raise its interest rate. This, however, raises the cost of the defending the peg which lead to market uncertainty and results in a speculative attack, as economic actors try to get rid of their assets in domestic currency and swap it for foreign currency (Obstfeld, 1994). In addition, the expectations of economic agents can influence the outcome of the crisis. “The sudden shift in market expectations from optimism to pessimism may be due to uncertainty about the future path of economic policy, or more specifically the willingness or the ability of the government to maintain the exchange rate parity (Setzer, 2006; 66).” For example, in the instance of high unemployment, economic agents might expect a loosening of the monetary policy due to the high cost of defending the peg. This again can lead to a speculative attack by economic actors who anticipate changes in policy.
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Eichengreen and Jeanne (1998) argue that the second generation of currency crisis explains perfectly the European crises of 1992-93 and Britain’s depart from the gold standard 1931. However, there are several key differences from the first generation of currency crises. First, there is a certain degree of asymmetry of information, as economic agents are not fully aware of the government’s policy plan and level of commitment to the peg and a shift in policy might indicate that the central bank is also changing its monetary policy (Eichengreen and Jeanne, 1998). In other words, the government’s willingness to resist pressure is unobservable and has the potential to cause panic among investors. This leads to the second point, namely that the second generation model of currency crises predicts that a crisis may occur as a response to certain political processes (Eichengreen and Jeanne, 1998). “Markets may only derive future economic policy from different political events. Uncertainty associated with policy changes then plays a central role in the shift of market expectation (Eichengreen, 2006; 68).” There are two main events that can trigger such a response – elections and a political regime change. For example, a shift to a leftist government that is concerned with high unemployment might drive the cost of keeping the peg, which alarms rational investors that there is a shift in economic policy. According to Willett (2004) in such scenario the government will have to raise the interest rate, which in turn will lead to lower economic output and will destabilize the exchange rate regime. However, economic actors might underestimate the government’s commitment to the peg and as such the speculative attack might be unsuccessful. In addition, as Willet (2004) argues, the government is in fact more likely to recognize that it cannot maintain the peg under a speculative attack and therefore abandoned it long before its foreign reserves are exhausted. An additional problem derives from the way investors decide how to invest (Dixit, 1989). In an environment of uncertainty will result in an incentive for investors to wait due to the fact that direct investments are largely irreversible. According to Dixit (1989) this means that investors will postpone any future investments which in turn will reduce the demand for domestic currency. Naturally, lower demand for the currency may lead to pressure on the government to maintain the peg by using its foreign currency reserves. Political uncertainty is also related to this process as it dissuades investors from investing, therefore lowers the capital flow and demand for the domestic currency and making the peg vulnerable to speculative attacks (Barro, 1991). However, Morris and Shin (1998) argue that the idea of self-fulfilling speculative attacks again does not explain the most currency crises, which seemed closely linked with shocks in the financial sector. This model seems P a g e 43 | 104
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to indicate that any shifts in the monetary policy of governments may cause a speculative attack and provides an overview of the relations between domestic economic policy and exchange rate regimes.
6.3 Third Generation Model A third generation model was developed after the Asian financial crisis of 1997 and it seeks to address the shortcomings of the previous two models. Burnside et al. (2001) argues that this can be attributed to two main reasons. “First, recent financial turmoil shows that the sudden stop or reversal of capital inflows causes severe international illiquidity and sharp economic downturns generally associated with high exchange rate volatility (Setzer, 2006; 68).” A second specific problem is the failure of previous models to explain the fact that currency crisis has been transferred as shocks across other countries. Calvo and Mendoza (2000) claim that closer integration and globalization portfolio diversification, have resulted in a higher degree of volatility and chance of contagion. The third generation model takes these two factors into account and explains why so many currency crises coincide with severe crashes on the financial market (Kaminsky and Reinhard, 1999) The core idea behind the model is that banks and firms in developing countries, and emerging markets have a critical currency mismatches on their balance sheets because of their tendency to borrow in foreign currency and lend capital in domestic currency. “Banks and firms face credit risk because their income is related to the production of non-traded goods whose price, evaluated in foreign currency, falls after devaluations (Burnside et al., 2001; 5).” In addition, banks and firms are also quite vulnerable to liquidity shocks because of their tendency to focus on financing longterm investments by using short-term borrowed capital. It is important to point out that the third generation model consists of several approaches to explaining currency crises. McKinnon and Pill (1998) for example, argue that the over borrowing by financial institutions and the trend to fund such investments, mentioned earlier, creates a moral hazard which forms a “hidden” government debt, which can be attributed to the willingness of governments to bail out such financial institutions. In other words, banks that have over borrowed might rely on the government’s fiscal P a g e 44 | 104
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policy to cover their debts by using taxation as a source of capital. Burnside et al. (2001) supports this theory and argue that in an attempt to assure the stability of the financial sector, the government may end up providing banks and other institutions with the incentives to engage in excessive borrowing. This destabilizes the financial structure as it makes it prone to a speculative attack, which can threaten both the banking sector and the currency. Chang and Velasco (2000) argue that a currency crisis is likely to arise if a country has a high amount of debt in a foreign currency and investors are doubtful of the government’s ability to repay the debt. This explanation establishes a direct correlation between external debt and currency crises, which is applicable to the case of emerging countries. Since these countries have a tendency to over borrow in a foreign currency, the resulting deficit can eventually cause panic on the financial markets. Krugman (1999) argues that these countries are usually characterized with excessive economic booms that lead to an optimistic market forecast, which results in lowering the prices of lending. These developments lead to asset price bubbles, which threaten both the exchange rate and the domestic economy. However, the banking system is not necessarily involved in third generation models and that two factors play a major role in such crises: the ability of firms to spend and capital flows that influence exchange rates. In fact, Krugman (1999) argues that this can be avoided by immediately implementing capital controls, which is what Malaysia did during the Asian Economic crisis. As such the third generation of crises models reveals the fact that currency crises and financial crises are interrelated (Burnside et al., 2007). The model seeks to explain the last major currency crises in the Asia and as such it has profound implications for this research.
a.
Twin Crises According to the third model of currency crises, financial crises and currency crises are
essentially linked. There are a wide variety of theoretical frameworks that explain this link. For example, Stoker (1994) argues that bank crises are essentially caused by balance-of payments issues. This is based on the idea that the external shock, such as the increase in foreign interest rates combined with a currency peg, will lead to foreign currency reserve loss. Stoker (1994) argues that if the issue is not addressed immediately, this will lead to a credit crunch that will eventually cause bankruptcies and a financial crisis. Scholars such as Mishkin (1996) support this hypothesis and argue that banks with a high amount of foreign debt will see their positions weakened if their debt P a g e 45 | 104
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is denominated in foreign currency. Therefore, a rapid devaluation will essentially lead to a banking crisis and to increased debt. Another set of arguments is presented by Chang and Velasco (2000) who point out that problems in the financial sector is what ultimately leads to the collapse of a currency. In this model the problem derives from the fact that the decision of the central government to bail-out financial institutions demands the creation of more money. However, by printing out money the government eventually causes a devaluation of the domestic currency on the financial markets. This devaluation is further fuelled by speculative attacks by foreign investors, who are concerned with the government’s ability to defend the peg. Under these circumstances the central bank is forced to use its foreign reserves in order to defend the domestic currency (Mishkin, 1996). A third framework argues that both types of crises occur simultaneously and have common causes (Kaminsky and Reinhart, 1999). A good example of this is the crisis in Mexico in 1987 which can be attributed to the exchange-rate oriented inflation stabilization plan. “Because inflation converges to international levels only gradually, there is a marked cumulative real exchange-rate appreciation. Also, at the early stages of the plan, there is a boom in imports and economic activity, financed by borrowing abroad (Kaminsky and Reinhart, 1999; 475).” As the account deficit of the country continues to grow, financial markets panic that the stabilization program introduced by the government will end up being unsustainable, which signals the beginning of speculation attacks on the domestic currency. The implications go even further due to the fact that the economic boom has been financed with external credit. This surge in back credit eventually results in an outflow of capital and crash of the assets market, which causes a shock to the banking system. McKinnon and Pill (1996) develop a model based on this framework that examines how financial liberalization in combination with microeconomic distortions make the effect of economic boom-bust cycles more pronounced. Gloldain and Valde (1998) develop a similar model that illustrates how sudden changes in the amounts of capital inflow and the international interest rates are in effect amplified by the role of the banks and how these can result in an exaggerated business cycles, which lead to financial crises and currency crises.
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7. Pre and Post Crisis Exchange Rate Regimes in Indonesia, Philippines, Malaysia and Thailand Having examined the regime choice theories and the pros and cons of different exchange rates in a pre-crisis scenario, it is time to address the first hypothesis made by this thesis. According to it, the immediate declared post crisis exchange rate regime will differ from the actual implemented one, as the exchange rate regime moves from a more flexible to a more managed one. In order to address this thesis will examine three countries’ pre-crisis and post-crisis exchange rate regimes by examining relevant data, which will be obtained via secondary and primary sources. This will provide an indication on whether the governments of these respective countries have stuck to their initially declared exchange rate regime in the post-crisis period and whether they have implemented a different one. If a fear of floating is present immediately after the collapse of the currency, then relatively high reserve volatility should be observed, which will be an indication that the government is managing the exchange rate regime. Finally, it should be noted that the section will also present some information on the US/DM exchange rate characteristics, which will be used a point of comparison. The rationale behind this decision is the fact that both the DM and the US were floating currencies and as such these characteristics can provide important insight on the rest of the currencies examined in this section.
7.1 The Crisis of 1997 and Exchange Rate Arrangements The Asian financial crises started in 1997 in Thailand and quickly contaminated the whole region of East Asia, which prior to the event was seen as prosperous and marked considerable growth, and until the crisis, the region was attracting over half of the capital inflows to developing countries (Sharma, 2003). The region had recently undergone a period liberalization in the early 1990s and according to Corsetti et al. (1998) this had caused large amounts of over-borrowing on foreign financial markets by both governments and the private sector due to the relatively easy access to capital. Political culture has played a large role in the events as well, due to the fact that P a g e 47 | 104
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prior to the liberalization the public sector had provided large financial support to the private sector (Corsetti et al., 1998). This trend has continued even after the effective liberalization of the Asian economies, with many private actors expecting public authorities to basically bail them out in case a problem arises (Corsetti et al., 2001). The official classification of the four countries in question, or the de jure classification, was that both Indonesia and Philippines were following a managed float and an independent float respectively, while Thailand had its currency pegged to an undisclosed basket of currencies (Hernandez and Montiel, 2001; 3). On the other hand, Malaysia, which according to Khor (2005) still has authoritarian political characteristics, had its currency pegged to the dollar. In the case of Indonesia, the government was aware that liberalization and high-capital mobility might put pressure on a potential peg so the country’s respective government decided to officially allow its currency to float (Sharma, 2003). However, due to the fact that the government wanted to retain Indonesia’s competitiveness and to have limited control over their currency, the country employed central bank intervention in order to manage the exchange rate regime on the financial markets. According to the Mundell-Flemming Framework this suggests fear of both real and nominal shocks, as the country tried to retain some of its monetary policy independence and combine it with exchange rate stability, while maintaining open capital markets. Thailand on the other hand, plagued by political instability, decided to improve the trust in the stability of its currency by fixing it to ‘undisclosed’ basket policy, therefore targeting inflation and improving its trade with the countries to which the exchange rate regime was pegged (Hernandez and Montiel, 2001). The Philippines, officially had declared a managed float, but its currency was de facto pegged to the dollar (Hernandez and Montiel, 2001). Finally, Malaysia had its currency officially pegged, which may reflect the fact that its authoritarian government perceived it as a source of economic credibility in an attempt to gain trust from international investors (Hernandez and Montiel, 2001). Four years before the crisis, these countries have had a more stable exchange rate in relation to the dollar than any other free-floating currency. Table 1 provides a short overview of the monthly nominal exchange rate volatility of these three countries, which again suggests that the rate has been highly managed in comparison to other floaters, in this case the DM to the U.S. dollar (Hernandez and Montiel, 2001).
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Country
Period
Range
Standard Deviation
U.S. /DM
Pre-crisis
0.083
0.024
Indonesia
Pre-crisis
0.033
0.007
Philippines
Pre-crisis
0.012
0.003
Thailand
Pre-crisis
0.016
0.004
Malaysia
Pre-crisis
0.027
0.007
Table 1- Source: Monthly Nominal Exchange Rate Volatility – Pre crisis; Source: IMF Hernandez and Montiel 2001 As the data presented in Table 1 illustrates, even though the Philippines pursued an independent float, its relatively small exchange rate volatility in relation to the US dollar, in comparison to other floaters such as the DM, suggests that the regime was in fact heavily managed. According to the “fear of floating” hypothesis, this pre-crisis behaviour is to be expected, as Indonesia, the Philippines and Thailand pegged their de facto exchange rates to the dollar due to four main reasons. First, it was a mean to keep their foreign debt, denominated in dollars, stable. Second, this was a mean to keep the levels of inflation in check and to provide price stabilization. Finally, this was a good way to ensure their competitiveness on US markets, as their manufactured goods were comparatively significantly cheaper (Setzer, 2006). This behaviour can be attributed to a fear of appreciation which would mean losing competitiveness. However, the increasing price of the dollar on currency markets led to many South Asian’s economies, which have adopted dollar pegged currencies, to lose competitiveness on the global markets, which slowed their growth considerably (Hernandez and Montiel, 2001). In addition, there was growing concerns among investors about the ability of these countries to serve their debts. This resulted in a reduced access to external credit, which was further complicated by the fact that large amounts of government bonds were coming to maturity, as they were predominantly short-term (Hale, 2011). Foreign lenders were well aware of the fact that governments in each of these three countries were leading account deficit policies due to the credit P a g e 49 | 104
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availability caused by the liberalization process. Furthermore, due to the specific political and economic culture of the region in which the public sector provided support for private one, governments unofficially promised bail-outs to businesses and private companies, which was in fact quite unrealistic given the financial situation in these countries (Dornbusch, 2001a). “Some corporations in those countries borrowed predominantly in dollars directly from abroad, but collected large shares of their revenue in domestic currency from domestic sales. As a result, borrowers accumulated large currency mismatches on their balance sheets (Hale, 2011; 4).” The appreciation of the dollar on financial markets, however, meant that a possible devaluation will lead to a high-rise in the external debt of these companies. As a result, many investors withdrew their capital from crisis prone countries, which served to further deteriorate the access to foreign capital and resulted in a credit crunch. In order to prevent this, however, these countries raised the interest rates to unreasonably high-levels in order to become more attractive to investors. Since the exchange markets were flooded with their currency they also started using their foreign reserves to buy the excessive currency and to try to keep their de facto pegs. Neither of these policies were actually sustainable. As a result, on the 2nd of July 1997 a series of speculative attacks followed, during which investors sold off their Thai Baht denominated assets (Hale, 2011). The Baht fell by 16% on the same day and as Hale (2011) points out, it lost over 50% of its value from January in the next year. Other countries’ currencies followed and were hit by speculative attacks, which essentially contaminated the whole region. In addition, Mishkin (1996) argues that the IMF’s fiscal conservative policies that were recommended for these countries simply helped in fuelling the severity of the crisis. These events have significant implications. First, it seems that the currency crisis and the devaluation that these countries experienced were fuelled by the domestic banks’ inability to deal with the rising amount of bad credit (Hale, 2011). Therefore, the beginning of the currency crisis was in effect caused by the preceding banking crisis. As such, it seems that the reasons behind the exchange rate regimes collapse can be attributed to the third generation model of currency crisis.
7.2 Post-Crisis Arrangements- Fear of floating Returning back to the characteristics of the fixed exchange rate, it can be argued capital outflows and inflows have seriously damaged the credibility of the pegs in these countries. This P a g e 50 | 104
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problem, combined with excessive short-term borrowing that East Asian countries have undertaken prior to the crisis, is what has led to the economic collapse (Dornbusch, 2001). Eventually, these countries were forced to devalue under the mounting pressure of capital outflows away from the region. These events have arguably caused “herding behaviour” amongst investors and serve to highlight that capital mobility can significantly undermine the stability of pegged exchange rate regimes (Hernandez and Montiel, 2001). In addition, the rising amount of debt has led investors to launch speculative attacks against these currencies. Eventually, the governments of Indonesia, Philippines and Thailand were eventually forced to leave their currencies to float, as maintaining the peg was impossible. According to Dornbusch (2001) argues that the rapid devaluation and the following slow readjustment of the economy led to increased inflation, many businesses filed for bankruptcy and many individuals fell below the poverty line. Therefore, the countries needed to adopt more flexible arrangement in order to reflect the new economic realities.
Pre-Crisis- De
Pre-Crisis- De
Jure
Facto
Post-Crisis: After 1997 De jure
Indonesia
Managed Floating
Fixed
Independently Floating
Philippines
Independently
Managed
Independently Floating
Floating
Floating
Thailand
Fixed
Fixed
Independently Floating
Malaysia
Fixed
Pegged
Pegged Arrangement
Arrangement Managed Floating Table 2: De Jure Exchange Rate; Source IMF
However, returning back to the first hypothesis made by this thesis it will be shown that this has not been the case. In fact, although ultimately a change has occurred and every country has established an initial free floating exchange rate regime immediately after the crisis, the de facto exchange rate of each one of these countries, except Malaysia, is in effect different to the de jury P a g e 51 | 104
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one. Introducing a new exchange rate can increase the trust of investors that a new more consistent policy line is being undertaken by the central government (Plumper and Neumayer, 2011). In addition, governments can seek to relief themselves from the responsibility of maintaining a peg and therefore in effect depoliticize the issue. In effect, this is aimed at benefiting from the traditional pros of more flexible exchange rate arrangement. This policy serves as a reassurance but has more crucial implications. Ultimately, this discrepancy can be explained by the usual characteristics of developing countries- relatively high-inflation, corruption, political instability and focus on developing exporting economies as a means of catching up. Returning back to the definition of pure floating exchange rate regime, one can deduce that they not only represent a problem in terms of inflation but that they can be extremely volatile when considering the domestic political and economic environments of these developing countries (Plumper and Neumayer, 2011). As Setzer (2006) argues, however the government will seek to manipulate the actual exchange rate on the financial markets by using the foreign reserves. In practice, there is a clear mismatch between the official state exchange rate and the actual behaviour of the central bank. In this way, developing countries can preserve their competitiveness, control inflation and reduce exchange rate volatility. If these assumptions are true, then these trends should be observable in the scenario explained in this case study. Returning back to the monthly nominal exchange rate volatility, one can argue that a considerable amount of flexibility is observed in the post-crisis economic environment, as shown in Table 3 (Hernandez and Montiel, 2001). The table represents data that has been collected by the IMF and as such it suggests that the de facto exchange rate regimes announced by these countries are correct (Table 2). Chart 1, presented below, also seems to confirm that a higher degree of exchange rate volatility in regards to the US dollar was observed. The chart represents the exchange rate of the Philippine peso (in gray), the Thai Baht (in blue), the Indonesian rupiah (in yellow) and the Malaysian Ringgit (in orange) against the US dollar. These findings would then suggest that the first hypothesis made by this thesis is incorrect.
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Country
Period
Range
Standard Deviation
U.S. /DM
Post-crisis
0.078
0.021
Indonesia
Post-crisis
0.230
0.063
Philippines
Post-crisis
0.068
0.017
Thailand
Post-crisis
0.070
0.018
Malaysia
Post-crisis
0.00
0.00
Table 3- Monthly Nominal Exchange Rate Volatility – Post- crisis; Source: IMF Hernandez and Montiel 2001
Chart Title 600.00% 400.00% 200.00%
USD/THB
USD/MYR
USD/PHP
7/1/2001
4/1/2001
1/1/2001
10/1/2000
7/1/2000
4/1/2000
1/1/2000
10/1/1999
7/1/1999
4/1/1999
1/1/1999
7/1/1998
10/1/1998
4/1/1998
1/1/1998
7/1/1997
10/1/1997
4/1/1997
1/1/1997
10/1/1996
7/1/1996
4/1/1996
1/1/1996
10/1/1995
7/1/1995
4/1/1995
1/1/1995
10/1/1994
0.00% -200.00%
USD/IDR
Chart 1- Source: OANDA- USD/THB; USD/MYR; USD/PHP; USD/IDR- Exchange rates
However, reaching to this conclusion by not examining further data will be incorrect. In order to further analyse the issue, the thesis will analyse numerical data provided by the IMF (Hernandez and Montiel, 2001). Table 4 represents the Monthly reserve volatility of each one of the countries that the study has been focused on so far, including Germany as a point of reference and having a floating currency. The latter is done, so that the data can be compared to the monthly reserve volatility of another country that has implemented a more flexible exchange rate regime. Examining the data reveals that the reserve volatility has not failed to decrease, but it has actually increased in some instances (Hernandez and Montiel, 2001). In addition, comparing it to a country that has been attributed with a with a floating exchange rate regime, it seems that the volatility for each of the three cases is considerably larger than the one prior to the crisis. A conclusion then, P a g e 53 | 104
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would be that while indeed Indonesia, Thailand and the Philippines allowed for greater flexibility when it comes to their exchange rates, the countries have undoubtedly used their reserves to influence the real exchange rate on the financial markets (Calvo and Reinhart, 2002). This conclusion is also supported by Hernandez and Montiel (2001) who argue that there is a clear distinction between the exchange rates that have been announced immediately after the currency crisis. As such, it can be argued that again there is a clear difference between the initially announced exchange rate regime and the one that is actually implemented. The findings presented by Hernandez and Montiel (2001) and examined by this dissertation clearly indicate that there is a fear of floating regarding the exchange rate regime. However, here it must also be pointed out that Malaysia has acted according to its official policy line, presented to the IMF and even though a collapse of the currency has occurred, the country has been reluctant to let its currency float.
Country
Period
Mean Absolute change
Standard Deviation
Germany
Pre-crisis
1.082
1.325
Post-crisis
1.225
1.535
Pre-crisis
2.038
3.086
Post-crisis
3.169
5.335
Pre-crisis
3.859
4.479
Post-crisis
3.458
4.470
Pre-crisis
1.850
2.927
Post-crisis
1.552
2.281
Pre-crisis
2.118
2.803
Post-Crisis
2.643
3.183
Indonesia
Philippines
Thailand
Malaysia
Table 4- Monthly Reserve Volatility; Source: IMF Hernandez and Montiel 2001 P a g e 54 | 104
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Table 4 suggests that there is a distinction between the exchange rate regime that was intended and announced to be implemented as a policy response during and after the crisis and ex the one that was actually implemented. The data presented by here seems to suggest that there is a fear of floating behaviour amongst developing countries in a post crisis scenario. According to the numerical data in regards to the reserve volatility, it seems that the countries have implemented an intermediately exchange rate regime under the form of a managed float. As it was argued earlier, developing countries are plagued by high levels of inflation and high price volatility and as such implementing an intermediate exchange rate regime is perceived by policy makers to be a way of addressing these issues (Setzer, 2006). In addition, a partial peg may help in strengthening the trade exchange with a country with which the peg has been implemented (Setzer, 2006). This explains why the three countries have returned to a “dirty float” to the dollar. In addition, it clearly represents an attempt to control the inflation levels and to provide a currency and price stability (Setzer, 2006). Therefore, an intermediary exchange rate represents an attempt to improve the levels of inflation by achieving price stability, thus improving trade balance. Finally, it is also important to point out that since a large portion of the external debt of such countries is denominated in foreign currency, implementing a limited control on the exchange rate means that governments can have limited control on the amounts of debt they owe. However, intermediate exchange rates have been considered by a number of academics to be inherently instable (Hefeker, 1996; Bubula and Okter-Robe, 2002). This leads to the argument proposed by bi-polar proponents, which was discussed earlier, i.e. that the only stable regimes are the pure float and the hard peg (Fischer, 2001). Willet (2005) argues that the Bretton-Woods system has shown that adjustable pegs are highly prone to currency crises in light of high-capital mobility. In addition, Frankel (2004) argues that the unholy trinity requirement can be met by introducing any combination of “exchange rate versus monetary policy adjustment”. As such, it can be argued that intermediately exchange rate regimes represent a serious hazard as in effect they try to reconcile the “impossible trinity” (Frankel, 2004). In addition, returning back to a partial peg does not seem to address the issue of the pre-crisis scenario. Here it is also important to return to the argument made earlier that a large amount of academics argues that such policies are not unsustainable (McKinnon and Ronald, 2002, and Combes et al., 2011). Willet (2005) also concedes this point and argues that in some developing countries the de facto regimes that contradict the official de jure regimes are not problematic and for example crawling peg has worked relatively well on several P a g e 55 | 104
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occasions. Combes et al. (2012) goes further and argues that an intermediately regime choice is not problematic itself, but the problem lies in the danger of a banking crisis, in accordance to the Third Generation Model that will be discussed later. According to this model it is the use of seigniorage as an absorbing method of fiscal imbalances is what essentially weakens the governments’ ability to sustain a managed float or a peg (Combes et al., 2011). However, as it will be argued later the fear of floating cannot be attributed to economic concerns alone. In fact, this policy approach represents a direct result of the levels political stability observed in the country, the type of government and the power of the interest groups involved in the political process.
7.3 Conclusions As this study illustrates, financial problems have essentially undermined the currencies of the countries in question and therefore the crisis corresponds to a third generation model of currency crises. The subsequent devaluation has further exacerbated the problems of the financial sector. This corresponds with the framework developed by Mishkin (1996) as the inadequate policies and actions by banks in these countries have amplified the pressure on the domestic currency. In effect the banking problems have caused the currency crises, as the central banks were unable to defend the de facto fixed exchange rates in the face of capital outflows and the result was rapid devaluation and collapse of the de facto pegs. The fear of floating behaviour was present prior to the Asian crisis; as Asian countries were reluctant to let their currencies float due to a number of economic and political factors. With the collapse of their respective currencies, however, these countries were forced to adopt more flexible arrangements. As chart 1 and Table 3 reveal, the volatility of these currencies did indeed increase immediately after the crisis, which seems to indicate that the governments had implemented more flexible exchange rate regime arrangements. However, the increased reserved volatility indicates that the governments of these countries have used their foreign reserves to influence the exchange rate regime, which indicates a more managed exchange rate regime.
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8. Interest Groups Classification, Political Interests and Exchange Rate Regimes – An Institutionalist Approach In order to examine the dynamics, which influence the fear of floating behavior in a postcrisis episode and the implementation of an exchange rate regime, different from the initially announced one, the research will examine the issue of currency preference amongst different political and social actors through the theoretical prism of institutionalism. A key factor in the political economy of exchange rate regimes and the institutionalist approach is the fact that certain interest groups have distinctive preferences in regards to the choice of an exchange rate regimes in order to maximize their own utility (Hefeker, 1997). This can be explained by the fact that states, economic agents and political actors all seek to influence institutional processes in order to maximize their own utility. Furthermore, the extent to which these groups can influence domestic policy making in regards to exchange rate regime is also dependent on the specific political system within a given county. In the case of a fixed regime, it is crucial to establish a favorable domestic environment that will support the peg, regardless of the costs involved (Setzer, 2006). If popular support is low, then the credibility of the government and peg may be weakened. Furthermore, low popular support also can create resistance with regard to the implementation of the necessary policies to defend the pegs. Broz and Frieden (2001) argue that this support is indeed important for maintaining the peg and proponents moving their support away from this stance might signal the start of a “devaluation cycle”. In addition, since economies are becoming increasingly liberalized, the exchange rate can serve as a way to retain competitiveness (Broz and Frieden, 2001). As such governments have to carefully examine the costs and benefits of stable exchange rates versus flexible ones (Frankel, 1999). For example, keeping a devalued exchange rate means that the export products will be more competitive on international markets, while imported goods will be more expensive on the domestic markets. Therefore, as Broz and Frieden (2001) argue, the real economic consequences of a particular regime will not be felt the same across all industries, which can basically create both “losers” and “winners”.
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There are numerous channels through which interest groups can influence policy makers and ultimately influence the decision making process. As such, they are of great importance fromm a viewpoint of rational institutionalism, as in effect through the political process and institutions, interest groups can shape economic policy (Olson, 2004). Olson (2004) argues that interest groups may express their political and economic preferences to the government through a transmission of information, engaging in political lobbying and contributing to particular campaigns. Frieden (1997) argues, however, that the dominant interest group will not influence policy permanently and that pressure on the political groups will occur only when there is a danger of crisis and exchange rate volatility. In addition, groups that lose from the chosen exchange rate regime will react negatively and will eventually organize politically against the policy undertaken by the government. In a traditional democracy, policy makers will have to pursue the policies that are of interest to politically powerful and strategically important groups as they otherwise risk an electoral defeat. “A country's exchange rate policy is then a combination of each sector's preference over exchange rate policy weighted by this sector's importance (Setzer, 2006; 115).” The last is especially true for developing countries where the interest of a specific sector will essentially dictate policy. This can be attributed to a number of issues such as low standard of living, unemployment and high inflation. The sector that contributes the most to addressing these concerns will most likely hold larger political power to influence decision making. Therefore, as the importance of that sector increases, the more likely will their preferences taken into account by policy makers. Bloomberg et al. (2004) argues that since in developing countries the tradable sector usually has the largest political power as it is considered to be the most valuable one by the authorities, then it may be the one to influence the political
8.1 Interest Groups in Favor of Fixed Exchange Rates Fixed exchange rate regimes prevent currency fluctuations and as such investment and trade can be conducted with minimal losses. However, the obvious tradeoff is that the domestic monetary policy and the balance of payment problem must be subordinated to the peg, which means loss of independent monetary policy. Hefeker (1997) argues that the interest groups’ involvement in monetary policy can be explained by the degree to which they are involved in either domestic or international economic activity. Therefore, it can be concluded that groups that are involved in P a g e 58 | 104
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international trade exports and investment will be the ones that are most likely to support a peg. This can be explained with the desire of export manufacturers to achieve price stability and avoid trade uncertainty that are created by the change in aggregate demand variations (Eichengreen and Frieden, 1993). The development of financial derivatives and the ability to hedge against risk has provided some degree of price stability even under a floating exchange rate (Steinherr, 1989). However, this policy suffers from two serious drawbacks (Hefekerer, 1996). First, hedging can involve some loss of capital and second it can be done effectively in a year in advance and the use of derivatives often provide a bail out clause (De Grauwe and de Bellefroid, 1987). In addition, Hefeker (1996) argues that models have shown that the lack of hedging against risk eventually diminishes the economic activity if financial risk is already too high. As such, firms may employ a wait-and-see attitude in order to avoid uncertainty which ultimately diminishes investment activities. Finally, it is important to point out that export sectors and portfolio investors are relatively insensitive to the loss of monetary autonomy, if stable exchange rates and capital mobility are in place (Setzer 2006). This fits with the idea that these interest groups will most likely prefer fixed exchange rates in order to divert risk away from their business activities. In addition, Hefeker (1996) argues that the export sector will most likely prefer an undervalued exchange rate as it improves its competitiveness on international markets. However, it must be noted that if the export sector is using imported components, in case of an over devaluation, the manufacturers might end up being hurt by the low exchange rate (Hefeker, 1997). This, Hefeker (1997) argues that government subsidies to the sector and tax breaks is a useful policy in improving the competitiveness of the manufacturers.
8. 2 Interest Groups in Favor of Flexible Exchange Rate Regimes The same approach can be employed when considering which interest groups are most likely to favor flexible exchange rates. As it was argued earlier, floating or flexible exchange rate regimes are less prone to speculative attacks and as such are less vulnerable to crises. In addition, they provide a chance for governments to pursue an independent monetary policy in combination with capital mobility (McDonald, 2007). Friedman (1994) argues that such regimes will be most favored by the non-tradable industries and import companies of tradable goods, as they are less P a g e 59 | 104
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sensitive to exchange rate volatility. In addition, some financial actors may prefer floating exchange rates, as hedging options provide some degree of risk controls and are an important source of profit for some financial institutions (Destler and Henning, 1989). However, it must be mentioned that if there is a strong connection between financial institutions and the manufacturing industries, banks might follow the preferences in the latter (Walter, 2008). This can be explained by the fact that in such scenarios, where financial institutions play a role in the management of a company or have supplied a large manufacturer with exclusive loans, banks and other such institutions will be inclined to support the company or the tradable industry in order for the latter to achieve better performance and thus larger capital profits (Walter, 2008). The independent monetary policy that a floating exchange rate regime provides can also help transform the central bank a last-resort-lender, which helps in reducing the probability of liquidity crises. As a result of these implications it can be argued exchange rate regimes offer a chance for the monetary authority to deal better with external shock with minimal disruption of real economic activity on the domestic market (Steinberg et al., 2015).
In addition, Friedman (1994) also argues that some of these interest groups will prefer a slightly higher rate of the domestic currency, in contrast to the tradable sector. This can be attributed to the fact that appreciation in the exchange rate in the context of an open economy makes the economic output of the non-tradable sector higher in comparison to other sectors. In addition, it must be briefly noted that consumers are also more likely to prefer a slightly appreciated exchange rate regime, as it makes foreign goods cheaper and more accessible, which has a positive effect on the living standards within a given country. However, it must be noted that since this eventually can lead to a negative trade balance, especially in the case of an underdeveloped economy, governments of developing countries are more likely to prefer a depreciated currency as it provides higher levels of competitiveness to their export sectors (Hall, 2008). In addition, keeping the exchange rate depreciated can lead to higher levels of foreign direct investments, as international companies will be enticed by the relatively cheaper labour. Finally, it must be noted that before elections in democratic countries the exchange rate regimes in developing countries have often seen sudden appreciation. According to Friedman (1994) this means that government tends to manipulate the exchange rate regime before elections in order to create the perception of improving socioeconomic conditions amongst the electorate. This points out that the consumers do have a P a g e 60 | 104
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certain amount of political power that the power relationship is not static and is constantly changing as a result of the actors’ influence and preferences.
8.3 Authoritarian Vs Democratic Regimes Another important aspect of the political economy of exchange rate regime choice, according to institutionalist theory, is the specific type of the government and the political regime, which play a role both in the choice of exchange rate regime and the willingness of the government to devalue its currency, as this has a direct impact on institutional arrangements. Broz (2002) argues that there are significant differences between autocratic and democratic regimes in monetary policy. This section will examine the problem of authoritarian and democratic exchange rate regimes choice. It will be argued that the type of government regime and the institutional quality of the respective states will have a profound impact on international monetary policy and behaviour. It will be claimed that facing high political costs, democracies in developing countries will depoliticize the issue by allowing it to float. However, since the exchange rate volatility hurts the most dominant interest groups and bears political costs to the authorities, the government will try to influence it by using its foreign reserves in order to create a sense of stability. Autocratic regimes, however, bear smaller political cots of devaluations and as such they can enforce the adjustments, which means that they do not feel the same domestic pressures caused by adjustments.
a.
Authoritarian Regimes The preferences of authoritarian regimes in developing countries derive from their specific
political characteristics. „Since the political decision making process in autocracies is generally less transparent than in democracies, autocracies find it particularly difficult to convince economic actors that its monetary authorities will not deviate from the announced policy ex post to generate higher inflation than expected (Setzer, 2006; 83).” Another crucial implication is that authoritarian regimes usually lack credibility amongst investors, which can be attributed to their lack of political transparency and legitimacy (Broz, 2000). Credibility plays an important part of the choice of an exchange rate regime and monetary policy as a whole, since the perception of investors and speculators about the intentions of a given government can have profound effects on the exchange rate regime. Therefore, authoritarian regimes will prefer to implement a pegged exchange rate P a g e 61 | 104
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regime in order to compensate for the lack of openness of the political and economic process, which otherwise would mean high inflation expectations. However, pegged exchange rate regimes have been described as “an inefficient means of generating credibility, given the availability of alternatives like central bank independence (CBI) that do not require a loss of exchange rate policy flexibility and that appear effective at reducing inflation (Alesina and Summers, 1993; 155).” The problem with this implication is that a central bank independence requires democratic arrangements, such as media monitoring, societal inflation “hawks” and an active political opposition in order to prevent the development of a strong and corrupt relationship between the bank and the government (Wittman, 1989; Broz, 2000). The possibility of such a relationship and the lack of institutional transparency makes pegged exchange rate regimes more attractive to authoritarian governments, as policy-makers perceive it as a way to achieve credibility and stability, which also explains why autocratic governments are more likely to adopt a peg (Broz, 2000). However, due to the coercive capabilities of such governments and their ability to suppress opposition, authoritarian regimes are significantly more insulated from the political effects of interest groups and the public and as such they are not obstructed to implement economic adjustments that correspond to the peg (Simmons, 1994). Therefore, as Broz (2000; 862) argues, lower political costs influence the likelihood that authoritarian regimes will choose a peg and stick to it. This offers a chance for these regimes to achieve the credibility they lack due to their restrictive economic policies and political repressions. In addition, developing countries suffer from high level of inflation, fixed exchange rates represent a method to control it, since central bank independence is hard to achieve under these political arrangements. If these arguments are indeed correct, then authoritarian regimes will be likely to return to a managed regime after the collapse in order to retain the deal with the loss their credibility after the devaluation (Steinberg et al., 2015). Therefore, the amount of political discontent and social disorder will be limited as authoritarian regimes are relatively well insulated against domestic interest group. In addition, governments will be reluctant to let their currency float on the financial markets in an attempt to retain their credibility. Finally, as fixed exchange rate regimes and price stability offer the establishment of more stable trade relations with developed countries, authoritarian regimes may perceive them as a way to speed their own economic development and improve their trade balance (Steinberg et al., 2015).
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b.
Democratic Regimes Democracies represent political systems in which the executive powers are delegated to
government through elections, which means that democracies are extremely sensitive to the political influences and mobilization of domestic constituents and interest groups (Milner and Kubota, 2005). Democratic regimes usually offer numerous channels through which interest groups can influence policy, including monetary policy. However, Setzer (2006) argues that the amount of power that interest groups can exercise depends heavily on the quality of the democratic institutions that have been set up, as weaker institutions are more likely to be influenced by interest groups and as such they are less insulated by domestic influences. In regards to macroeconomic policy this can lead to significant policy inconsistency and unsustainability (Steinberg et al., 2015). For example, the weak character of the Thai democratic system has played a large role in the development of the crisis, as that the fragmented and weak party system has given financial and industrial interest an efficient way to influence governmental policy (Haggard, 2000). The influence of these groups over domestic economic policy-making has been used prior to the crisis to push for rapid increases in the availability of credit, which in turn has exacerbated the severity of the economic crash even further (Steinberg et al., 2015). However, democracies do not usually suffer from the lack of credibility and transparency that can be attributed to authoritarian regimes and in addition, they can easily implement central bank independence, since it is not contradictory to the overall political framework (Hall, 2008). Thus exchange rate regimes in democracies are a combination of electoral and legislative institutions and these can affect the preferences of politicians and policy makers in regards to a specific regime (Bernhard and Leblang, 1999). Clark and Hallerberg (2000) argue that democratic political regimes prefer floating exchange rate regimes. This can be explained by the authorities’ attempt to depoliticize the exchange rate regime and thus free themselves from political responsibility in regards to its stability. Therefore, policy makers can, at least theoretically, argue that they are not directly responsible for the exchange rates and thus avoid taking the political responsibility that is associated with the failure of a peg (Steinberg et al., 2015). Bernhard and Leblang (1999) argue that the internal economic and political characteristics in a democracy play a crucial role when it comes to adopting a specific exchange rate regime. In an empirical study conducted by Bernhard and Leblang (1999), a set of variables, including vulnerability to shocks, capital mobility, partisanship and electoral cycles, and their effect on P a g e 63 | 104
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exchange rate regime choice are examined. Their findings reach to the conclusion that in political systems, in which the cost of electoral defeat is high, a flexible exchange rate regime will be preferred. While in weak and noninclusive systems, the cost of being a part of the opposition is larger, since being a minority means lesser control over policy choice, the ruling party will seek to distance itself from the issue of exchange rate regime stability by adopting a more flexible model in regards to its monetary policy (Hall 2008). “On the other hand, in systems where coalition governments are common and the policy process is open, a fixed exchange rate can provide politicians with a focal point for policy agreement (Bernhard and Leblang, 1999; 93).” Keeping all of this in mind, it is crucial to examine what are the implications for developing democracies. As the latter often suffers from poor institutional arrangement and weak governments, it is far easier for interest groups to influence specific policies (Hall, 2008). Much like their authoritarian counterparts, the export and manufacturing industries play a crucial part of their economy and overall developmental strategy (Setzer, 2006). Therefore, although democratic governments will be eager to depoliticize the issue of exchange rate volatility, they may seek to address the issue of their weak institutions, appease both domestic interest groups and investors, and control inflation, by managing the exchange rate regime (Hall, 2008). This will also allow them to retain at least partially their independent monetary policy due to their more flexible monetary arrangements (Setzer, 2006).
c.
The Role of Political Instability in Democracies and Exchange
Rate Regimes It can be concluded that fixed regime may help in stabilizing the external trading environment and achieve a certain set of macroeconomic policy goals. However, returning back to the impossible trinity, democratic policy makers in developing countries will prefer an independent monetary policy in the face of capital mobility (Bernhard and Leblang, 1999). Democracies do not usually suffer from the same legitimacy problems that are attributed to authoritarian regimes. As such, democracies inherently do not need a fixed regime in order to enhance their credibility. Yet, the research does seem to suggest that the electoral system does play a role in this choice (Watson, 2007). Edwards (1996) argues that the political instability plays a crucial factor in the choice of exchange rate regimes and the occurrence of currency crises, since weaker governments have P a g e 64 | 104
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shorter-time horizons to ensure adjustment of the economy and benefiting from the long-term effect of the evaluation. The line of this argument is also proven by the J-curve (Figure 1), as governments need to react during the initial economic slowdown and political instability diminishes the trust in them, thus giving them less time to implement policies that will help the economy to adjust. In fact, numerous studies (Frieden, 1991). Bernhard and Leblang (1999) find a positive correlation between political uncertainty and exchange rate volatility, confirming that the former contributes significantly to the possibility of a devaluation, since investors are not sure of the government’s intentions regarding macroeconomic policy, which in turn can cause capital outflows. This can prove significantly problematic in the face of capital mobility and therefore political uncertainty may increase the exchange rate volatility. Therefore, changes in cabinet, political upheavals and social discontent influence capital and investment, and such can have a profound effect on the real exchange rates. In addition, events that have not been anticipated by the financial markets further increase this volatility. Bachman (1992) confirms this hypothesis and argues that political news and developments are crucial for exchange rate traders, as it gives them an overview of the economic situation and helps them anticipate the reactions of the government in terms of policy. These findings have an impact for exchange rate regimes in developing countries. Developing countries suffer from high volumes of political uncertainty, which affect the exchange rate volatility (Watson, 1997). In addition, developing countries usually focus their economic development policy on the export industries and therefore high-exchange rate volatility combined with capital inflows and outflows, can have severe implications for the export industries and on the volumes of trade and investments (Hall, 2008). “Exchange rate volatility, in turn, makes the external trading environment riskier, hurting international traders and investors as well as the exportoriented tradable sector (Frieden, 1991; 431).” This can explain why developing countries are reluctant to let their currency float on the financial markets and try to influence the exchange rate regime accordingly. However, it is also true that the exchange rate is also a product of the political process, as interest groups try to influence governmental policy. In this respect, Bonomo and Terra (2001) argue that politicians in developing countries fall into two categories – representatives of the non-tradable and the tradable industries. Representatives of the former are usually more numerous and they will prefer overvalued rates or flexible exchange rates (Hefeker, 1997). The P a g e 65 | 104
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prominence of the export industries in developing economies, however, means that they are most likely to have considerable influence on governmental policy. As such, the de facto exchange rate will be a combination of economic and political factors. The problem in this scenario, according to Edwards (1996), has significant implications for developing countries facing the prospect of devaluations. The problem derives from the fact that weak governments, which have pegged their exchange rate, face large external and internal pressure to keep their commitment and failure to appease the relevant interest groups or investors may result in a loss of power for those governments (Watson, 1997). Regardless of whether the regimes are officially or only practically pegged, a sudden devaluation and increase in exchange rate volatility, will then undermine the government’s credibility (Hefeker, 1997). This can result in a profound reluctance to abandon the peg, even under severe financial problems and the possibility of a twin crisis. All of these implications point out that in a post-crisis scenario, governments will face large pressure to deal with the initial shock of the devaluation. Since devaluations can cause significant political upheaval and economic damage, the government may be eager to control the increase in real exchange rate volatility by introducing an exchange rate regime, which is different from the one that was initially announced, with the aim of lessening the initial economic shock and achieve price stability.
8.4 Hypothesis II and Hypothesis III According to the institutionalist analysis provided in this section, the specific political arrangements and interest groups can impact the choice of an exchange rate regime through their preferences. Rational institutionalism assumes that all actors try to maximize their utility and satisfy their own need and as such they interact with other political actors in an attempt to influence monetary policy. The next section will focus on two countries, namely Thailand and Malaysia, which were examined earlier, and will argue that the implementation of a de facto regime soon after the crisis can be attributed to the preferences of specific interest groups, such as the manufacturing sector and the political elites. Furthermore, political uncertainty, instability, the quality of the democratic institutions and the power relations between interest groups has further contributed to the fear of floating behaviour, even after the recent collapse of their currency (Hefeker, 1997). As a result of this, after the collapse and the forced abandonment of the peg, the more flexible exchange rate regime arrangement is likely to be abandoned as well in favour of a more managed one, as a P a g e 66 | 104
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direct result of both economic and political concerns. However, authoritarian regimes will be more likely to return to a peg after the crisis, both in terms of de jure and de facto, as they are usually well-insulated against domestic political pressures. It will be argued that this can be attributed due to the prominence of the export sector and the fact that increased exchange rate volatility can undermine investment flows and the volume of trade (Broz, 2000). In addition, due to their low credibility and level of transparency, authoritarian regimes will use the peg as a way to reassure investors of their stability, legitimacy and commitment.
9. Case Study: Thailand and Malaysia 9.1 Case Study: Introduction The chosen states to be examined in order to address hypothesis II and III will be Thailand and Malaysia, which can be attributed to several reasons. First, earlier both countries have experienced a currency collapse which can be explained by the third generation model of currency crises. However, both prior and after the crisis, the two countries have been reluctant to let their currency float on the financial markets. While in Thailand the new monetary arrangements after the crisis were undeniably more flexible, strong evidence suggest that the exchange rate regime was still managed after the crisis. Malaysia, on the other hand, returned to a more managed monetary arrangement even after the collapse of its currency (Setzer, 2006). The following section will argue that this behaviour can be at least partially explained by the specific characteristics of the Malaysian political system immediately before and after the crisis. It will be argued that political concerns combined with the mobilization of interest groups and the stability of political institutions during and after the crisis period, play an important part of the fear of floating behaviour. The second rationale behind this choice of case studies is the type of the government systems in the two countries. In the early 90s, Thailand had undergone a democratization process, which established a constitution and marked the beginning of a new political era for the country (Hicken, 2009). On the other hand, the Malaysian political regime is regarded as having authoritarian characteristics. “If the crisis generated political change in Malaysia, it appeared to be in the direction of increasing concentration of authority in the hands of the prime minister and creeping P a g e 67 | 104
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authoritarianism (Haggard, 2000; 107).” As such Malaysia and Thailand represent a good opportunity to examine closely the political processes within each country prior and after the crisis, which will enable the thesis to test the validity of the second and the third hypotheses.
9.2 Thailand and the Asian Crisis of 1997 Prior to the financial crisis, Thailand had experienced a strong economic growth that averaged nearly 10% a year in the period of 1987- 1995 (Fischer, 1998). The economy was based around the export sector, comprised of low skill/low wage jobs, which attracted large amounts of foreign direct investment in producing goods that were being exported to developed countries (Ciminero, 1997). In addition, as it was argued earlier, prior to 1997 the Thai Baht was pegged to the US dollar, which resulted in a stable trade relationship, as Graph 5 indicates. The graph illustrates that prior to the financial crisis, there was a low degree of exchange rate volatility between the Baht and the US. However, this also meant that if the dollar was to increase in real price, the real price baht increased as well. The de facto fixed exchange rate regime that Thailand employed in turn led to the development of a relatively large trade surplus with the US, as the price stability encouraged further investment and economic activity between the two countries. In addition, as long as the baht was pegged to the dollar, Thailand was perceived as an attractive investment opportunity (Ciminero, 1997). It soon became clear that two major factors had contributed to the slowing of real GDP growth (Warr, 1998). The first one was the large and widening gap in the current account deficit and in this respect Haggard (2000) points out that by 1996 the deficit was equal to 8.1 % of GDP. The second factor was the health of the liberalized and deregulated financial sector. Since the baht was pegged to the US dollar and the interest rate was relatively small, it became increasingly cheaper for Thai financial institutions and companies to borrow in dollars. The Thai government embarked on massive public spending campaigns and encouraged the country’s banks to lend excessive amounts of capital for real estate investment (Ciminero, 1997). “Since the exchange rates were pegged against the US dollar, companies were not concerned with having to earn domestic currency to repay the loans in dollars (Lai, 2000; 67).”
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Graph 5- Source: FRED
However, the weakness of the dollar was the factor on which the Thai economy was reliant and therefore when the dollar appreciated on the financial markets, Thailand competitiveness was damaged significantly, as the baht rose in relative price to other currencies (Hicken, 1999). Thai exports became relatively more expensive in comparison to competitors and the amount of external debt increased even further. The low real growth significantly diminished the ability of the government to repay its debt. In addition, a devaluation was practically impossible, as it would increase the amount of foreign debt and worsen the economic situation. This economic crisis was followed by a deep political crisis, which lead to the previously democratically elected government of Banharn to collapse in 1996 (Hicken 1998). The new government was headed by Chavalit and his New Aspiration Party, and was compromised by a broad coalition of six other parties (Hicken, 1999). Chavalit’s idea was to establish a coalition of technocrats in order to deal with the early warning indicators. However, the real problem of the Thai economy was not initially in the banking sector but rather with domestic companies, which had over borrowed (Overholt, 2002). On February 1997 Somprasong Land was forced into a default and the country’s largest finance company, Finance One, was seeking a merger in order to avoid collapse (Haggard, 2000). This prompted the government to come out with an official statement that was aimed to ensure foreign investors that the exchange rate regime will hold and to ward off speculative attacks. Returning back to the first P a g e 69 | 104
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two models of currency crises, examined in earlier sections, this move makes sense as it is aimed at ensuring foreign investors about the government’s intent to defend the peg (Overholt, 2002). However, since the events developed in the accordance with the third generation model, the government’s statements simply alarmed financial markets that the country is plunging into a deeper crisis. On July 2, after a massive speculative attack, which drained large amounts of the country’s foreign reserves, Thailand was forced to abandon its currency peg.
Graph 6- Source: World Bank (0 represents the best value, 100 represents the worst value)
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a. Thai Government’s Response to the Crisis The crisis directly resulted in a change of the government and brought the reformist party to office (Haggard, 2000). This fits with Cooper’s (1974) observation that a rapid devaluation can cause a severe political crisis and lead to a change of the government. Furthermore, the governance quality of Thailand was rather poor and was suffering from a lack of credibility, which is one of the reason why monetary stability has been preferred, over independent monetary policy. Graph 6 represents the World Governance indicators for Thailand in the period of 1996-2013, with 0 being the best value and 100 being the worst value. As the graphs indicate, immediately prior and after the crisis, Thailand was suffering from poor accountability, credibility, weak institution and inadequate legal system. These developments lead to the government and the IMF to work together on a rescue program to get the country out of the crisis, which included complete restructuring of the government’s macroeconomic policy. The problems that were identified by the IMF as crucial to the Thai economy were the unstable and devalued currency, the declining levels of investments, which resulted from uncertainty and lack of trust among foreign investors towards the Thai economy, and excessive amounts of foreign debt (Furman and Stiglitz, 1998). The IMF programme introduced high interest rates in order to attract investments, combined with fiscal and monetary tightening. However, this response has been widely criticized by many academics, who have argued that the programme has had a perverse effect (Krugman, 1999). In fact, as Haggard (2000) argues, instead of stabilizing the exchange rate regime, the programme has alarmed the financial markets “that further decline was in store, contributed to the overshooting of exchange rate adjustments, and severely compounded problems in the financial and corporate sectors.” In addition, the crisis prompted changes in the Thai constitution that seem to be a direct response to the economic collapse. The constitution involved a drastic change in the Thai political and electoral system, introduced new regulatory mechanisms in regards to financial institutions and companies, aimed at increasing the transparency and stability of institutions. The new constitution also included provisions, which ensured that it will become the overarching legal document. However, as Haggard (2000) argues, actual implementations were rather slow and the new governments took a rather timid approach to the issue. He points out that even “with a near complete collapse of confidence on the part of both the market and the international financial institutions, Thai politics reverted to intercoalitional conflicts (Haggard, 2000; 94).” In addition, as it was P a g e 71 | 104
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shown earlier, Thai authorities soon resumed managing the exchange rate, albeit to a lesser degree than before, as indicated by the exchange rate volatility.
b. Interest Groups in Thailand The government’s timid actions can be explained with the specifics of the Thai political system. Politically, Thailand had a coalition-based party system, which according to section 8 will prefer a less-flexible exchange rate regime. The issue was that the constitution produced a system that favoured personal campaigns rather than partisan ones (Hicken, 1999). This, according to Handley (1997) resulted in politician turning to financial institutions and corporate actors in an attempt to finance their political campaigns. This inevitably led to the development of strong personal connections between political elites and economic elites, with the former turning to the latter for support. Another problem derives from the way economic liberalization and democratization was done in the early 90s (Coleman, 1999). Prior to these events in Thailand followed a developmental state model, i.e. focusing on export industries in order to achieve development (Satiniramai, 2007). However, similar to many developing countries, this reliance on export industries continued after the liberalization of the economy. Yet, it is important to point out that the main rationale behind this choice is the fact that many developing countries seek to achieve economic development through increasing their trade surplus and attracting FDI, thus the previous model of development was largely preserved (Coleman, 1999). “Competent, meritocratic bureaucracies and the concentration of decision-making power in relatively insulated economic agencies played a crucial role in the model of the developmental state (Haggard, 2000’ 20).” A crucial policy of the developmental state was to socialize political and industrial elites in order to set common goals and maximize efficiency. In addition, technocrats were given substantial independence to pursue monetary and fiscal policies and were insulated against political pressures (Satitniramai, 2007). According to Satitniramai (2007), the political economy of Thailand both prior and after the crisis never managed to abolish the idea that economic technocrats should be given freedom in devising such policies. The power of industrial elites in Thailand cannot be simply attributed to the electoral system due to the fact that the export sector was (and still is) perceived to be key to the economic development of the country (Satitniramai, 2007).
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implemented in Thailand left many financial institutions and firms concentrated in the hands of a small elite (Table 5). As Table 5 reveals, over 50 % of the total market share capitalization was controlled by 15 families and the five largest banks in the countries possessed 70% of the market share just prior to the crisis. This data reveals that the private sector had considerable leverage over the political process which is proved by the fact a considerable amount of businessmen had directly entered politics (Pasuk and Sunsgidh, 1999). The problem was prominent due to the coalitional character of the Thai cabinet, which often resulted in weak government. In fact, the Thai government often accommodated the political investments made by the private sector by allocating key positions to business members and channelling fiscal resources to relevant supporters (Pasuk and Sungsidh, 1996). As such, the Thai democracy faced severe problems in holding private power in check.
Country
Ownership
The share of total
Share of total market
Market share of five
Share of firms unable
Concentration in
outstanding shares
capitalization
largest banking
to cover interest
10 largest firms
owned by 5 largest
controlled by top 15
institutions, end-
expenses from
(3 largest
shareholders
families
1997 (share of bank
operational cash flow
loans)
(peak number and
shareholders)
year) Thailand
44.0
56.6
53.3
70.0
32.6 (1997)
Malaysia
46.0
58.8
28.3
41.0
34.3 (1998)
Table 5- Corporate Ownership in Thailand and Malaysia (Haggard 2000) Another problem derived from the significant political influence of domestic banks and financial institutions. In fact, as Doner and Unger (1993) point out there was a large pressure on behalf of the banks to deregulate and liberalize the financial sector. The first liberalization program allowed commercial banks to sell mutual fund and underwrite debt instruments. In addition, banks developed strong connections with domestic companies, which further increased the political power of the private sector (Overholt, 20002). Haggard (2000) argues that this developed in an economically unhealthy preference for quick profit, which resulted in a bias in the maturity structure of Thai institutions towards their debt towards the short term. A rather curious P a g e 73 | 104
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characteristic of this system was the government’s inability to regulate this behaviour and its role in effectively providing bail outs for banking and financial institutions. A good example of this was the use of the government owned Financial Institutions Development Fund to bail out the Bangkok Bank of Commerce as early as 1991, as basically 27 percent of the bank’s total assets were in fact nonperforming (Nukul Commission Report, 1998). The following years showed that his issue had become even more difficult to overcome. “The government agreed to purchase a substantial stake in the bank through the FIDF, but without any writedown of shareholder capital or replacement of management (Haggard, 2000; 25).” This behaviour developed into a source of economic vulnerability due to the poor regulation of the system and the complete lack of transparency (Corsetti, Pesenti and Roubini, 1999). The weak coalitional governmental system, combined with the fact that many politicians were funded by the private sector and the capture of the cabinet itself by business elites, resulted in the so called “economic moral hazard” (Haggard, 2000; 24). Examining these characteristics of the Thai political and economic system, it becomes clear that the private sector and the business elite had excessive political power. This argument is supported by the data in Table 5 and by the direct involvement of the export and the financial sector in the Thai political processes. On closer examination, it becomes clear why the Thai economy has adopted both de jure and de facto pegged exchange rate prior to the crisis and had pegged its currency to the dollar. Even though Clark and Hallerberg (2000) argue that democratic regimes should prefer floating exchange rates, as they in effect depoliticize the issue, while retaining some control through the central bank, the case of Thailand seems to contradict this claim. This can be explained by the other variable that were examined earlier. First, as Milner and Kubota (2005) argue democracies are very sensitive to the political influence of interest groups. In this sense, one should expect that if the tradable sector has a political dominance, fixed exchange rates are more likely to be adopted. However, if the financial or the non-tradable sectors have more political influence, then floating exchange rate will be preferred (Bonomo and Terra, 2001). As it was shown, the Thai political sector prior to the crisis has been characterised by significant political influence from the tradable sector that had developed extremely close connections with the financial sector. Following the rationale described earlier, it is then safe to argue that the Thai Baht was fixed to the dollar in order to achieve price stability and enhance trade relations with the US. In fact, the Thai export sector and political had perceived the peg as a way to increase economic activity P a g e 74 | 104
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between the US and Thailand (Frieden, 1991). In addition, political stability and the quality of the democratic process can have an impact on the choice of exchange rate, as it was argued in the previous section (Setzer, 2006). Considering the low stability of the Thai coalitional governments and the poor quality of the democratic process in the country explains why the political system was basically captured by the private sector. In addition, according to the theoretical model described earlier, since developing countries lack political credibility, which can potentially increase their exchange rate volatility, they will be likely to favor exchange rate stability (Frieden, 1991). All of these factors can explain Thailand’s preference for a peg. However, as it was shown in Table 1, Thailand had in fact adopted the pegged exchange rate as both de facto and de jure policy prior to the crisis. Thus, in order to address Hypothesis 2, the same political dynamics will have to be in place in the post-crisis time period.
c. Interest Groups and Power Balance in Thailand In order to examine whether interest groups have influenced Thai policy makers into adopting a fear of floating behaviour, the thesis will once again return to the government’s response to the crisis. First, although some companies were nationalized or bankrupted, most were in fact rescued by the government as they were perceived as too big to fail (Haggard, 2000). In fact, as Haggard claims only 2 percent of financial assets run by banks were merged or restructured and 11 from other financial institutions. In addition, although the constitutional reform was supported by both major parties, business elites were initially sceptical about the reform as outlined by (Phongpaichit and Baker, 2005). However, the government did eventually manage to gather support for the constitution, which resulted in a protest of business representatives in an actual support of the constitutional reforms. Yey the reforms never did address the fact that the political system was in effect penetrated by individuals who were both politicians and large businessmen (Haggard 2000). Another problem, however, derives straight from the fact that the Thai political economic system was largely reliant on FDI flows in its development (Amar, 2011). While this is a viable economic strategy, it does give large amounts of power to foreign MNCs, which were mostly Chinese in Thailand at the time of the crisis (Ammar, 2011). This has increased the political leverage of multinationals, which also can explain why the Thai government has pegged the Baht to the dollar in an attempt to provide price stability. P a g e 75 | 104
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And while, the business has supported the constitutional, there was a backlash against the government macroeconomic policy. ”In seeking to pass reform legislation, these problems were compounded by the fact that the Senate contained a number of businessmen who would be adversely affected by proposed reforms and had the constitutional power to review, and thus delay, reforms (Haggard, 2000; 97).” This resulted in a deep division over the issue of economic policy in post-crisis cabinet. The issue was exacerbated by the economic policy advocated by the IMF and the interest rate recommended by it. A major complaint was that the tight monetary stance proposed by the IMF and the business sector argued that the Thai government should focus on stabilizing the baht and saving the financial sector (Ammar, 2011). In addition, there was pressure in regards to the high interest rates implemented by the government, with business groups advocating for either relaxing them or devising new financial instruments to ensure the flow of credit (Ammar, 2011) “Given the coalition nature of the government and the close links between all parties and the private sector, the government was more responsive to these pressures than in South Korea, and it made a number of concessions to private-sector demands (Haggard, 2000; 98).” In addition, private interests, basically proved to be an obstacle to implementing a policy that would liberalize the flow of foreign direct investments (Ammar, 1997). Although such actions were sanctioned by the IMF, with every new letter of Intent from the organization, private interests would resurface. These findings show that variables such as political stability, interest groups and the political system play a significant role in the fear of floating behaviour, as argued by Hypothesis 2. In fact, the wide political involvement of the corporate sector in the post-crisis monetary arrangements and their specific objectives, suggests that a rational institutionalist explanation holds true. Therefore, national leaders must maintain support from powerful domestic interest groups in order to support their bid to power, as established by the institutional arrangements (Bueno de Mesquita et al., 2003). In addition, since the country had experienced a twin crisis, the economic impact of the currency crisis was amplified even further, which suggests the involvement of a wide section of economic and political actors in the post-crisis exchange rate arrangements. As it was shown the crises has led to the dissolution of the previous cabinet which has been replaced by another weak cabinet. In addition, business elites had undoubtedly a large influence on the government’s policy. In terms of exchange rate regimes, however, these elites demanded monetary stability to be a top priority. On the other hand, the IMF perceived the situation as one that demands sweeping reforms and privatization. Based on these developments, one can safely argue that the new Thai government P a g e 76 | 104
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simply took the middle road. In its officially announced exchange rate regime, the government adopted flexible arrangements in an attempt to depoliticize the issue, as argued earlier (Sharma, 2002). Thus, it seemingly followed the recommendations put forward by the IMF. However, the pressure from domestic interest groups, MNCs and financial institutions, which were closely tied to the manufacturing sector and were interested in its profitability, lead to the implementation of a managed float de facto regime. In other words, the Thai government gave into the demands of monetary stabilization, as falling from power, much like their predecessors, seemed to be a feasible outcome (Bloomberg et al., 2005). This has put strain on the government and can explain why the monetary policy has behaved under the fear of floating model. This also explains why the de facto exchange rate, differs from the officially announced one and is thus it differs from the initially intended and announced one. Farrelly (2013) argues that not much has changed following the crisis and in fact the power of certain elites and their ability to manipulate policy, including monetary policy, making represents a crucial problem for Thai democracy (Farrelly, 2013).
9.3 Malaysia and the Asian Crisis of 1997 Prior to the crisis the Malaysian political system was basically considered to be an authoritarian regime and even though the crisis did produce a political change, the country is still perceived to have strong authoritarian characteristics (Lim and Goh, 2012). A good example of this fact is the tight control of the government over the media and the lack of opposition of the country’s ruling parties, which in the last elections won over 90% of the votes (Haggard, 2000). However, similarly to Thailand the country appeared to be economically sound before the crisis. As Jomo (2003) and Ahtukorala (1998) argue the economic growth in Thailand often ran budget surpluses and had consistently low levels of inflation. However, much like Thailand, the borrowing rate in Malaysia increased threefold between 1994 and 1997 (Bank Negara Annual Report, 1997). “However, overall debt remained modest when compared with GNP (45.6 percent), its maturity structure did not appear particularly troubling (76.1 percent in medium- and long-term debt), and debt service ratios were extremely modest (5.7 percent of exports) (Haggard, 2000; 59).” There were early indicators of an economic bubble appearing on the domestic market, as much of the capital that was borrowed was invested in property and shares. Yet, as Chua (1998) points out the banking sector seemed relatively less prone to crises than in Thailand, since the government had P a g e 77 | 104
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put comprehensive regulation of the sector. However, just before the Thai crisis, the economy was gradually slowing down. After the attack on the baht, the Malaysian ringgit began to depreciate and although an attempt was made to defend the peg, the government quickly abandoned these efforts after a week (Lim and Goh, 2012). In fact, in the begging of 1998 the Malaysian currency depreciated 50% against the dollar (Graph 7). A number of political factors contributed to this collapse, although regional contagion has been instrumental in the beginning of the crisis. The issue derived from uncertainty in the government’s intentions, when the prime minister of Malaysia announced “a war on speculators” in the first half of 1997, which points out to the problem of perception lag amongst investors (Haggard, 2000). However, a speech in front of the IMF made by the Prime minister, simply fuelled the fear among investors, which led to massive capital outflows as they were not sure in the government’s attempt to defend the currency.
Graph 7- Source: FRED
Soon after that Malaysia experience the biggest collapse of its stock market in the country’s history. In fact, as Ariff and Abukabar (1999; 420) argue, between July and December in 1997, the “composite index of the Kuala Lumpur Stock Exchange (KLSE CI) fell by 44.9 per cent.” Even though a slight recovery occurred in the beginning of 1999, the index fell again. In addition, the property bubble also subsequently there was a burst of the property bubble, which was followed by P a g e 78 | 104
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a massive capital outflow (Haggard, 2000). This in turn made the banking sector experience nonperforming loans, which rose from 2.18 per cent to 11.45 per cent in July 1998 (Malaysia EPU, 1999). Private estimates for such loans were, however, higher than the officially announced and some companies had started to roll over debt in order to survive (Ariff and Abukabar, 1999). This led to a decline in the amount of borrowing and financing and the crisis soon spilled to the real sector. The collapse of the Ringgit combined with the slump in the property market and the contractionary effect of the stock prices resulted in a general contraction of the domestic demand, which was felt throughout the economy. Private investment inflows also suffered a severe contraction due to the volatility of the exchange rates and the fall in demand (Jomo, 2003). As a result, domestic oriented industries and the non-tradable sector were severely hit, and the levels of FDI inflows to the country diminished significantly. The result was and eventual collapse which led to a contraction of over 23% in the construction sector, 9% in the manufacturing sector and 6% in the agriculture sector (Ariff and Abukabar, 1999). These had a large impact on the labour market as well, with the rate of unemployment and inflation rate plummeting to a 6.2 inflation rate in June 1988 and employment growth contracting by 3% (Ariff and Abukabar, 1999). The latter was, however, somewhat mitigated by the 2 million migrant workers and the increase of public spending. The overall erosion of households’ welfare suffered and had a lasting impact on the quality of life in Malaysia. As it was shown in Section 6, the government of Malaysia was running a managed float and a fixed exchange rate for different periods of time prior to the crisis. As the Mundell-Flemming framework suggests, it seems that the peg was implemented to provide monetary stability and to ensure stable trade and investment relations, while forgoing independent monetary policy. In addition, since Malaysia was an authoritarian state with a strong export sector, it is safe to assume that a fixed exchange rate will be preferred by policy makers in order to soften the implications caused by Malaysian’s low political credibility and to ensure better trade relations with its trade partners (Yagci, 2001). Furthermore, according the analysis conducted earlier, a political regime that lacks transparency and legitimacy can be expected to adopt a peg in order to make up for its lack of these components. This is especially true in the Malaysian case, as the regime was considered to be extremely ethnocentric and repressive, which raised doubts amongst foreign investors in regards to the government’s economic policy (Yagci, 2001). The poor quality of Malaysian politics is illustrated in Graph 8, with the score 0 being the best possible and score 100 P a g e 79 | 104
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being the worst possible. The graph indicates poor quality Malaysian governance in all variables, especially government effectiveness, which did play a part in the perception of foreign investors and speculators. Under such conditions, a floating exchange rate regime would lead to high volatility of the real exchange rate and the possibility of rapid capital outflows (Gomez and Jomo, 1997). In addition, the government was highly involved in the financial sector and the private sector, with both being highly regulated by government institutions, which created further concerns amongst foreign investors about policy transparency (Jomo, 2003). The government’s focus on growth through exports emphasized the importance of the export industries, which meant that the latter was likely to be treated favourably in regards to policy.
Graph 8 - Source: World Bank (0 represents the best value, 100 represents the worst value)
This again fits with the earlier outline of the role of interest groups in monetary policy, as Malaysia had chosen to focus on managed exchange rate regime arrangement in order to aid its P a g e 80 | 104
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export sector and achieve stable trade relations with the US. The policy was successful and the Malaysian economy had achieved unprecedented economic growth. This analysis, however, provides an interesting insight about the crisis in Malaysia. The property bubble and the high over borrowing on the financial markets points out to a third generation model of currency crises (Ariff and Abubakar, 1999). However, as it was noted earlier, it seems that a large portion of the financial collapse can be attributed to the fact that foreign investors were not sure of the government’s intentions of defending the peg. This led to a large speculative attack and indeed the central bank abandoned the peg after just a week, before it has exhausted its foreign reserves (Jomo 2003).
a. The Malaysian Government’s Response to the crisis and Political Change The currency and financial crisis is Malaysia did fail to produce a massive change in the political system unlike in Thailand. However, it did lead to a change of the Prime Minister of the country, namely Anwar, who seemingly started a process of democratization. As Haggard (2000) argues, however, the political process did end up having even more of an authoritarian character than prior to the crisis. Anwar quickly implemented capital controls in order to limit the outflows of capital from Malaysia and undertook an economic reform, inspired by the policies that were advocated by the IMF, which can be summarized with “an IMF package without the IMF” (Haggard, 2000). The government cut spending drastically in both the public sector and in terms of subsidies to the private sector, delaying construction projects that were either perceived to be controversial or of non-strategic value, deterred capital imports of some big state-owned enterprises and also cancelled its foreign investments (Bank Negara Annual Report, 1997). Anwar also made it clear to the banking sector, that firms, which have suffered large economic losses and are impossible to keep running, would be not kept afloat and financial regulation will be tightened. The rationale behind these decisions was to consolidate the vulnerable and crucial companies, and to initiate a complete restructuring of the banking sector (Hasan, 2002). In addition, interest rates were raised, which was a policy implemented by the IMF in other countries hit by the crisis (Hasan, 2002). The IMF was not approached, however, as the Malaysian cabinet perceived an IMF intervention as restrictive in regards to their available policy tools. In addition, Anwar argued that Malaysia will remain committed to a flexible exchange rate and will not impose further control on P a g e 81 | 104
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capital flows (Jomo, 2003). This points out to the fact, the Malaysian cabinet initially decided to leave the peg and adopt a more flexible monetary policy.
b. Malaysia and Interest Groups- Prior and After the Crisis The subsequent developments in response to Anwar’s policies are crucial as they reveal a dynamic typical of the Malaysian system and reveals the reasons why the country returned to the peg. As it was shown in Table 2 in Section 6, the Malaysian government returned to fixed currency arrangements, even though Anwar had previously supported a flexible rate. If the second hypothesis is correct, this can be attributed to a mix of economic and political reasons. In addition, if hypothesis three is correct and the Malaysian government has preserved its authoritarian character, then an official return to the more managed arrangements should be observed, as authoritarian regimes are less pressured to depoliticize the issue. This can be explained by the fact that the government will want to preserve price stability, attract investments and focus on providing a solid economic basis of expansion for the tradable sector. Graph 4 illustrates this fact well, as there is no substantial change in the governance indicators in the years after the crisis. Anwar’s policies were quickly overturned and lead to his downfall as a Prime Minister of Malaysia, which can be attributed to the political divisions that emerged in the ruling UMNO party (Jomo and Gomez 1999). In essence, his policies were represented a significant detraction from the official party economic policy that was called New Economic policy and the National Development Policy (Khor, 2005). The aim of this programme was to achieve development and growth through enhancing the capabilities of the export sector. However, more importantly, it was aimed at wealth redistribution, namely to ensure the involvement of bumiputras in the Malaysian economy and ownership (Khor, 2005). “One component of the New Economic Policy was the requirement that firms over a certain size—with some exceptions, such as export-oriented enterprises—sell 30 percent of their shares to bumiputras (Haggard, 2000; 28).” Furthermore, the government was significantly involved in the financial sector and its influence extended to the stock market. The NEP and the NDP were criticized for their ethnocentric character and for their preferred approach. In fact, as Gomez and Jomo (1997) argue that privatization and liberalization effectively led to a moral hazard, as they were implemented with the aim of ethnic redistribution and favoured certain key enterprises, providing them with relaxed financial and tax regulation. In addition, privatization P a g e 82 | 104
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of public owned enterprises and infrastructure was negotiated and sold to a limited number of firms (Gomez and Jomo, 1997). This points out to the fact that certain industries were perceived to be more important to the Malaysian economy and therefore received a preferential treatment, when it comes to policy-making. It can be argued then that the ethnocentric policies and the preferential treatment of certain industries have created a strong relationship between private sector and the government, which increased the power of the private sector as a both a political and economic actor, with the Malaysian government being heavily involved in the domestic economy (Khor, 2005). In addition, since a profitable export and manufacturing sectors were crucial to the overall development strategy, combined with an ethnocentric approach to both macroeconomic and microeconomic policies underlined the importance of this actor in the overall policy strategy of the authorities. This also explains why a peg was considered to be more adequate for the NEP and the NDP. Table 5 confirms these findings and reveals that the ownership of firms and the total market share was heavily concentrated in a tight elite, much like in Thailand (Haggard, 2000). This can be explained by the preferential treatments that such firms have received on behalf of the government, in its attempt to centralize the economic ownership in the hands of a selected few. The policy undertaken by Anwar, however, did represent a detraction from the official economic direction of the government policy and as such it was widely criticised. In addition, the government used force and coercion to deal with the possibility of anti-government protests (Lim and Goh, 2012). However, Anwar‘s unpopularity within his own party got him ousted by his rival Mahatir Mohammed. Mahatir quickly consolidated his power by putting Anwar on trial, implemented a strict capital control programme and returned to the peg to the dollar. In addition, Mahatir resumed preferential treatment of certain industries and the bumiputra ethnic group (Haggard, 2000). These events are important as they reveal a lot about the way interest groups interact on the Malaysian political scene. The new prime minister blamed corruption and instability on foreigners, which is also indicative of the ethnocentricity of his policies (Haggard, 2000). In addition, Mahatir tightened the control of the central bank and in fact undertook direct control of the Finance Ministry (Jomo, 2003). The ousting of Anwar, however, did provide a chance of the opposition to mobilize and as a result, several protests were conducted by “Muslims disaffected by the treatment of Anwar, to portions of the urban middle class, social activists, grassroots organizations, and NGOs seeking P a g e 83 | 104
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to capitalize on the crisis (Case, 1999; 6-7).” The protests were, however, successfully suppressed by the government and Mahatir, who realizing that the opposition is becoming more organized, called or a snap election in 1999. Yet, even though Mahatir’s cabinet effectively controlled the media and had strong support from the private sector, the opposition did manage to obtain 40 % of the vote, while the National Front coalition, led by the UMNO managed to preserve its majority (Haggard, 2000). According to Haggard (2000), this initiated a process of even tighter political and economic control in the hands of a small elite, which can be explained by an attempt by the new government to suppress the opposition. Furthermore, Mahathir drew on the loyalty of party and business supporters to tighten the leadership within the UMNO, thus establishing his own personal dominance. This analysis clearly points out to the fact that the public, the middle and the lower class had low impact on monetary policy, which fits in the institutionalist analysis provided in this research. In addition, the financial sector, which was in effect controlled by the Malaysian government and was heavily regulated, was unable to influence exchange rate policy to any significant degree due to its interdependency with the authorities. Furthermore, while the country had experienced a contamination under a third generation model of crises, the speculative attack that followed can be explained by a second generation one. This implies that the lack of trust in the government’s intentions on behalf of international investors had a large role to play, in regards to the eventual monetary policy arrangements. Haggard (2000) argues that on the one hand the government had undertaken reforms in regards to the bank recapitalization, nonperforming loans and institutional quality, with the aim to restructure the economy. On the other hand, the Malaysian government eventually undertook a strategy that relied heavily on an interventionist approach. This is well illustrated by the fact that Mahatir resumed support and direct involvement of a number of public and private companies (Hasan, 2002). Even though the government's official stance was that businesses should not be bailed out by public funds, in practicality the government had used public finance to help businesses that were perceived as being of strategic importance (Jomo, 2003). All of these point out to the fact that a regime with authoritarian characteristics and sufficient political leverage will be able to better deal with the costs of the economic adjustment in a post crisis scenario. However, the prominent importance of the business sector and the lack of legitimacy and transparency on behalf of the Malaysian government can explain the return to the fixed exchange rate arrangement, in accordance to the analysis conducted in Section 8. In a sense, these findings P a g e 84 | 104
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reveal that authoritarian governments in developing countries are also likely to be reluctant to let their governments to float (Jomo, 2003). In addition, the Malaysian government simply did not need to depoliticize the issue, as social discontent and the opposition were silenced quick and effectively (Jomo, 2003). This means that implementing a peg in the case of Malaysia, considering the low legitimacy and transparency of the government, and the low political shock, was indeed a viable option. In addition, as Section 7 has argued, an abandonment of the peg occurs far before the foreign reserves are exhausted, which means that the Malaysian government did possess the necessary resources to return to the peg (Haggard, 2000). The findings presented in Section 9 reveal some crucial data in regards to post-crisis arrangements in developing countries, when analysed through the prism of institutionalism. First, politics, interest groups and the power balance do play a significant role in the “fear of floating” hypothesis. In fact, in an attempt to maximize their utility, political and economic actors try to influence policy through the use of the established political system. In fact, since a currency crisis can cause a significant amount of political instability, interest groups will be even more proactive in their attempts to capture the policy-making process. Second, authoritarian regimes are able so mitigate the pressure from some domestic interest groups and as such will not be inclined to act in accordance to the fear of floating model, which supports the third hypothesis made earlier. This leads to the conclusion, that the very arrangement of domestic political institutions has a significant impact on how interest groups behave and influence monetary policy. In the case of Malaysia, the government was not simply an agent, but it also fits in the role of a “principal”, as it sought to maximize its own utility through the choice of an exchange rate regime.
10.
Conclusion
The choice of an exchange rate regime is one of the most important macroeconomic policy decisions that a policy maker must make, which can be attributed to the overall impact of monetary policy on the rest of the economy (Setzer, 2006). Current literature has examined the issue of exchange rate regime choice in a pre-crisis environment in great detail, employing both theoretical and empirical research in order to address the issue. Exchange rate regimes have a considerable impact on price stability, volumes of trade and capital flows and even though the debate has been often introduced as a choice between a peg and a float, research points out that wide variety of P a g e 85 | 104
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monetary arrangements exist. As the research has argued, the emergence of intermediately exchange rate arrangements represents an attempt to reconcile the impossible trinity of economics. This type of monetary policy has been increasingly implemented by developing countries, as the liberalization of markets and the need to attract investment has put pressure on their currencies. As the discussion in section III has suggested, each exchange rate regime has a specific advantage and disadvantage. Pegged exchange rate regimes are usually associated with considerably improved inflation performance (Palley, 2003). Due to these reasons, countries implementing fixed exchange rate regimes can develop better trade relations with the country to which the former’s currency was pegged. Floating exchange rate regimes on the other hand, allow for bank and monetary independence, which is crucial when it comes to external and internal economic shock adjustments (Palley, 2003). However, as the research argues, given the volatility of capital flows, political instability and uncertainty play a role when it comes to investors’ trust. Research, however, points out that there is a clear misalignment between the officially announced exchange rate regime and the one that is actually implemented, especially when it comes to developing countries (Calvo and Reinhar, 2002). According to the fear of floating hypothesis, this can be attributed by the fact that emerging markets are seeking to achieve the price stability that a pegged currency offers, while maintaining monetary policy independence. However, economic policy inconsistencies can cause severe currency crises, which not only have profound economic effects, but also cause political turmoil and destabilization. The liberalization of international markets has represented a significant trade opportunity for developing countries, but the volatility of international capital flows has undermined the stability of their currencies and the ability of their governments to defend them. A rapid devaluation and an exchange rate collapse can have significant economic short-term effects, slow growth and seriously damage the export sector, while the economy adjusts (Combes et al., 2011). Furthermore, the economic collapse can significantly destabilize the domestic political system, as the ruling government will take the brunt of the crisis and may fall from power. As the three models of currency crises, briefly discussed in this research, have shown, investor expectations, government’s credibility and the stability of the banking sector can pose a considerable danger for the stability of an exchange rate regime, due to the possibility of rapid capital outflows and speculative attacks. As Cooper’s (1974) study has shown, rapid devaluations and currency crisis represent a considerable threat to governments in developing states, as the usual low political stability is undermined even further by P a g e 86 | 104
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the perception of government failure. Furthermore, the initial economic shock has a negative impact on the economic preferences on a number of domestic actors, including sectors dependent on imports, the general public, financial institutions and the manufacturing sector, regardless of the fact that a devalued currency can be beneficial for the balance of trade in the long term (Setzer, 2006). Considering these implications, the behavior of governments in developing countries in regards to an exchange rate regime choice in a post-crisis environment has not been addressed to a large extent in international relations and political economy literature. The problem has been perceived as being of interest to the field of economics, but as the research has demonstrated, a rapid devaluation can cause significant political instability within a given country. In addition, as neoliberal theory points out, economic relations have considerable implications on the way countries interact on the international arena and as such the choice of an exchange rate regime in a post-crisis environment can reshape the political arrangements and the outlook of the international affairs of a given state (Cohn, 2012). Furthermore, even though earlier research has sought to examine the issue, findings have remained rather limited and therefore this research has sought to address this gap. The correlation between this issue and the field of international relations in this sense can be easily established, as monetary policy and currency choice represent an important policy tool, through which a given state is integrated within the global economy and thus can have significant implications on the way it interacts with other states (Frieden, 2014). The research has proposed three hypotheses: developing countries will continue to act under the fear of floating hypothesis; the fear of floating behavior is largely influenced by domestic political processes and interactions between various interest groups, shaped by domestic institutions; and the political arrangements in terms of a democratic versus authoritarian regime characteristics play a major role in shaping the decision about the official announcement of an exchange rate regime. The research has applied a rational institutionalist theoretical framework to the research objectives, which borrows from the tradition of classical economics and assumes that all social actors are both rational, and they seek to maximize their own utility. In this sense, institutions are established in order to set up the formal “rules of the game” and to lower transaction costs of negotiating during the policy-making process (Pierre et al., 2008). Furthermore, the theory borrows from the “principal-agent” model of economics, under which actors delegate responsibilities to another party, in this case the government. However, since all actors are interdependent due to the specifics P a g e 87 | 104
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of their social interaction, the latter will also seek to satisfy its own political and economic goals. The rational institutionalist approach differs from neoliberal theoretical analysis, however, in the sense that it allows for focusing on the specific institutional arrangements and interest groups preferences on both a domestic and international level, while neoliberalism focuses specifically on the institutional, economic and political channels through which states cooperate (Cohn, 2012). Therefore, the rational institutionalist approach has allowed for this research to provide and insight on an issue considered to be mostly economic through the lenses of international relations and international political economy. Based on the data presented in section VII on the Asian financial crisis, the thesis has concluded that after a crisis period, developing countries are likely to continue to manipulate the real exchange rate of their currency through their foreign currency reserves. Therefore, even though more flexible arrangements have been allowed, the de jure announced flexible arrangement differ from the de facto managed float that these countries have implemented. As such, it can be concluded that even after a currency crisis and the collapse of the real exchange rate, developing countries will still behave as described by the fear of floating hypothesis. While this can be partially attributed to economic problems, such as price stability, monetary volatility and trade stability, the research has argued that key reasons for the fear of floating behaviour can be attributed to the specific political processes within developing countries, political instability and the quality respective institutional arrangements. In the case of Thailand, for example, this was done due to the political instability of the country, caused by the crisis, the sudden devaluation, and the strong political influence of the export and manufacturing sectors. The new Thai government tried to depoliticize the issue and thus move the problem away from the public sphere by officially letting the baht float on the financial markets after the currency’s collapse (Satirinamai, 2007). However, since political power was essentially focused on the hand of a small elite, the government continued to manage the exchange rate regime in order to address the concerns of the political and economic actors, that were perceived to be of strategic importance and had significant political influence (Farrelley, 2013). By doing this the new Thai cabinet distanced itself of the problem politically, but it continued to play a role in the real exchange rate in an attempt to speed up the development of the country and appease the strategically important export sector. This fits with the explanation provided by rational institutionalism about internal policy processes and in this particular scenario the government can be perceived as both an agent and a principle actor. On the hand, the new Thai government wanted P a g e 88 | 104
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to avoid the political costs of an unstable exchange rate and to appease the politically powerful economic elite (Hall, 2008). On the other hand, it acted as an agent on behalf of domestic industrial interests, which held a significant stake in the government. Therefore, it can be concluded that the fear of floating behaviour was largely a result of internal political processes, which fits with the proposition made by the second hypothesis introduced by this research. Much like Thailand, the Malaysian government was reluctant to let their currency float on the financial markets. Unlike the former, however, Malaysia had officially implemented a fixed regime prior to the crisis and retained a de facto peg after the economic collapse, which can be attributed to several reasons. Although Malaysia is officially a democracy, its political system has been attributed with a number of authoritarian characteristics. As such, social discontent and the actions of the opposition were quickly silenced, and political power was immediately consolidated by the new prime minister. Second, Malaysia had pursued a specific set of policies that include the active involvement of the state on the domestic markets (Jomo, 2003). As such, the initially proposed “IMF approach to the crisis”, which called for a higher level of liberalization, was not considered in line with the NEP policy, pursued by the authorities and favoured by the highlyethnocentric political elite. This meant that since the government retained its grip over key institutions and the media, no need to de-politicize the issue was present (Bernhard et al., 2002). On the contrary, the government needed to assure foreign investors, who were mistrustful of the government’s intentions, that price stability is ensured. Considering the lack of economic transparency of the Malaysian government and its specific economic strategy, based on attracting FDI, returning to the peg could be expected. The case study is indicative of the fact that authoritarian regimes are less likely to implement a regime, which is different from the one that was initially announced as they need to provide a “credibility anchor, while also being one are well insulated against the political influence of certain domestic interest groups (Hall, 2008). Again, this explanation fits with the institutionalist explanation of policy making, as the quality and type of domestic intuitions have played a role in shaping policy preferences. This analysis fits with the third hypothesis made in this research and shows that the type of a political regime is correlated with how a developing state chooses its exchange rate regime in a post-crisis environment. Furthermore, even though there was no distinction between the de jure and the de facto exchange rate regime, it shows that authoritarian regimes are reluctant to let their currency float. P a g e 89 | 104
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The research has addressed some key points in regards to exchange rate regime choice and state behaviour in a post-crisis environment, and in the process it has contributed to the institutionalist explanation of policy-making and expanded upon previous research. As such, the thesis has addressed the issue from the perspective of international political economy and traditional international relations theory. As it was pointed out throughout this research, the choice of an exchange rate regime has profound implications on how states interact and on the way they are integrated into the global financial markets. Thus, economic relations between states can be perceived as a channel through, which international affairs are conducted. The choice of an exchange rate regime in a post-crisis environment has additional implications for the way the domestic political economic system of a country operates and this research has demonstrated that interest groups, economic actors and political elites interact in a way that is aimed at maximizing their own utility. However, specific power relations, political uncertainty, institutional arrangements and the specific political regime shape these interactions and have an impact on the eventual result of policy in regards to the choice of an exchange rate regime in a post-crisis environment. Finally, it must be pointed out that the thesis is not without its limitations and while it does provide a theoretical foundation for future analysis, the research itself is not exhaustive. While the case study approach and the flexible research methodology has been helpful in addressing the research objectives, employing a different methodology may reveal more about the validity of the hypotheses made by the thesis. Nevertheless, the thesis has contributed to the debate by delving further into the relationship between the fields of economics and international relations, and has shown that the political process can have a significant impact on policies that are not traditionally a subject of public sphere debates.
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