thesis- martin belchev- exchange rate regime choice in developing countries

9/2/2015

Political

Economy

and

Exchange

Rate

Regimes: Developing Countries’

Exchange Rate Choice in Post-

Crisis Scenario

Martin Belchev: Student Number S2570866 UNIVERSITY OF GRONINGEN

COURSE: MA INTERNATIONAL POLITICAL ECONOMY THESIS SUPERVISOR: DR. RICHARD GIGENGACK ADDRESS: 23 Pehoten Shipchenski Polk N62, Entrance A, Flat 17, Kazanlak, Bulgaria PHONE NUMBER: 00359888184735

The Political Economy of Exchange Rate Regimes in Developing Countries

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Content

1. Introduction ............................................................................................................................................ 5

1.1 Hypotheses- Exchange Rate Regimes in а Post-Crisis Scenario .......................................................... 8

2. Methodology and Structure of the Thesis ............................................................................................. 10 5

3. Exchange Rate Regimes ....................................................................................................................... 12

3.1 Fixed Exchange Rates ........................................................................................................................ 13

3.2 Flexible Exchange Rates .................................................................................................................... 15

3.3 The Economic Trilemma and Exchange Rates ................................................................................... 17

3.3 Intermediary Exchange Rates ............................................................................................................. 20 10

4. Exchange Rate Theories and Developing Countries ............................................................................ 23

4.1 Mundell-Fleming Framework............................................................................................................. 24

4.3 Bi-polar Hypothesis/Hollow Middle Theory ........................................................................................ 1

4.4 Exchange Rate Regime Choice for Developing Countries- Towards an Institutionalist Approach ..... 2

5. Fear of Floating .......................................................................................................................................... 5 15

5.1 Currency Devaluation .......................................................................................................................... 5

5.2 Economic Effects of Devaluations ........................................................................................................ 5

5.3 Political Implications of Devaluations ................................................................................................. 7

5.4 Fear of Floating ................................................................................................................................. 10

6. Currency Crises and their implications for Developing Countries ....................................................... 12 20

6.2 First Generation Model of Currency Crises ....................................................................................... 12

6.3 Second Generation Crisis Model ........................................................................................................ 14

6.3 Third Generation Model ..................................................................................................................... 16

a. Twin Crises .................................................................................................................................. 17

7. Pre and Post Crisis Exchange Rate Regimes in Indonesia, Philippines, Malaysia and Thailand ......... 19 25

7.1 The Crisis of 1997 and Exchange Rate Arrangements ....................................................................... 19

7.2 Post-Crisis Arrangements- Fear of floating ....................................................................................... 22

7.3 Conclusions ........................................................................................................................................ 28

8. Interest Groups Classification, Political Interests and Exchange Rate Regimes – An Institutionalist

Approach ...................................................................................................................................................... 29 30

8.1 Interest Groups in Favor of Fixed Exchange Rates ........................................................................... 30

8. 2 Interest Groups in Favour of Flexible Exchange Rate Regimes ....................................................... 31

8.3Authoritarian Vs Democratic Regimes ................................................................................................ 33


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a. Authoritarian Regimes ............................................................................................................... 33

b. Democratic Regimes ................................................................................................................... 35

c. The Role of Political Instability in Democracies and Exchange Rate Regimes .................... 36

8.4 Hypothesis II and Hypothesis III ........................................................................................................ 38

9. Case Study: Thailand and Malaysia ..................................................................................................... 39 5

9.1 Case Study: Introduction .................................................................................................................... 39

9.2 Thailand and the Asian Crisis of 1997 ............................................................................................... 40

a. Thai Government’s Response to the Crisis .............................................................................. 43

b. Interest Groups in Thailand ...................................................................................................... 44

c. Interest Groups and Power Balance in Thailand .................................................................... 47 10

9.3 Malaysia and the Asian Crisis of 1997 ............................................................................................... 49

a. The Malaysian Government’s Response to the crisis and Political Change ......................... 53

b. Malaysia and Interest Groups- Prior and After the Crisis ..................................................... 54

10. Conclusion ............................................................................................................................................ 57

List of References: ........................................................................................................................................ 62 15

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Abstract:

The problem of choosing an optimal exchange rate regime is crucial policy area, as it can have

direct effect both on the volumes of trade and investments, and can have important implications for

the levels of external debt. Events such as the Asian Financial Crisis of 1997 and the Argentinian

crisis indicate that developing countries often lead economic policy inconsistencies, which can lead 5

to a severe financial and currency crisis. As such the aim of this thesis is to examine the factors

that lead to the exchange rate regime choice adopted by developing countries in a post-crisis

environment. This thesis will argue 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 10

democratic regimes can put pressure on their respective governments and essentially influence the

choice of an exchange rate regime. Finally, the thesis will argue 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. 15

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Running Title: The Political Economy of Exchange Rate Regimes in Developing Countries


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1. Introduction

Choosing an exchange rate regime is one of the most important policies that a government

must undertake, as it represents a set of policy tools and institutional arrangements which result

into one of the core ways with which a state is integrated within the international markets

(MacDonald, 2007). The exchange rate regime is thus in effect a system, established by 5

governments and monetary authorities, which dictates how the domestic currency is managed

against foreign currency. Auboin and Ruta (2012; 3) point out that real exchange rates, which

represent the “relative prices of tradable to non-tradable products”, are key component of economic

policy and can influence the overall performance of the economy through numerous channels such

as trade, the allocation of capital and labour between the tradable and the non-tradable sectors, 10

capital inflows and outflows, and asset prices. Thus implementing effective exchange rate can have

a large effect on growth, which can be perfectly illustrated by the rapid economic development of

East Asian countries. “An exchange rate that made exporting relatively attractive was clearly a key

component of East Asian countries’ rapid economic growth over the past several decades

(Takatoshi and Krueger, 1999; 1).” Therefore, the process of crafting such policy is of upmost 15

importance to a wide range of both national and international factors such economic output, trade

and political relations between states (Auboin and Ruta, 2012). A rather good example of the latter,

is itself the inception of the international monetary system as the nineteenth century saw an attempt

to impose some kind of order in terms of monetary policy by implementing a “classical” gold

standard (Kettel, 2004). This has resulted in an unseen thus far level of stability and economic 20

growth for its participants until its collapse with the outbreak First World War. Subsequent attempts

to establish new system has led to the creation of the Bretton Woods system, which introduced

fixed yet adjustable exchange rates and led to a new period of stability and “presided over the

greatest boom in the history of global capitalism” (Kettel, 2004; 5). Keeping all of this in mind, it

can be concluded that the choice of an exchange rate regime has serious implications for the fields 25

of international relations and international political economy. Having an impact on issues such as

development, trade and even supranational organisations, such 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). This holds true especially for developing countries, which are often using exchange


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rate regimes as a way to strengthen their competitiveness on the international markets or to

strengthen their trade prospects, by reducing price volatility.

Increased capital volatility and liberalization policies, however, have 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 the degree of which 5

volatility and market failure can undermine development, growth and political stability emerging

markets. “Financial crises are often associated with significant movements in exchange rates, which

reflect both increasing risk aversion and changes in the perceived risk of investing in certain

currencies (Kohler, 2010; 39).” These rapid depreciations of real exchange rates are referred to as

currency crises in academic literature and can have considerable implications for both the domestic 10

economy and the political system of a given country. Developing countries in particular are very

vulnerable to such shocks, especially considering the fact that currency crises are often preceded

by serious problems in the banking sector, and usually occur in the aftermath of financial

liberalization (Kaminsky and Reinhart, 1999). According to LeBlang (2003) one of the main

reasons behind this vulnerability can be attributed to the fact while wide economic liberalization 15

has been implemented, many developing countries still use exchange rate policy as a buffer between

domestic and international markets, which makes their currencies vulnerable to capital flows.

A collapse of an exchange rate regime implies that a given country will have to adopt more

flexible monetary arrangement in order to meet the new economic realities. However, theories such

as the fear of floating hypothesis point out that developing countries in general are reluctant to let 20

their currency floats on the financial markets in an attempt to avoid the increased volatility of the

real exchange rate, caused by the movement of capital. This has resulted in 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 (LeBlang, 2003). While the research pointing out to this behaviour

in non-crisis times is plenty, there has been little research on how and why developing countries 25

choose a specific exchange rate regime in a post-crisis scenario. Furthermore, most models dealing

with exchange rate regime choice usually focus on non-crisis episodes. Setzer (2006) argues that

initially analysts focused mainly on the model of optimum currency area, which is based on the

notion that 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. Another approach to the issue 30


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of has been the so-called Capital Account Openness Hypothesis which became prominent in the

90s of the 20th century (IMF, 2003). The main argument of the hypothesis is that due to the increased

capital mobility, countries with open capital account 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). 5

However, another set of determinants that can potentially influence the choice exchange

rates regime has been the institutional and historical characteristic of specific states (Edwards, 1996;

Poirson, 2001). These variables are often a subject of analysis of political institutionalism. This

approach is well established in the fields of international political economy and international

relations examines variable such as political stability, inflationary bias, central bank stability, 10

institutional quality and the specifics of the political economy of a given country (Bearce, 2003).

Rational choice institutionalism in particular poses a rather interesting proposition in regards to

policy making, as it encompases the utility-maximizing approach, typical of economic approaches.

Institutional analysis, combined with the rational choice theories, assumes that utility-maximizing

social actors and states “are central actors in the political process, and that institutions emerge as a 15

result of their interdependence, strategic interaction and collective action or contracting dilemmas

(Pierre et al., 2008; 10).” Therefore, institutions are established and continuously reformed due to

the fact that they fulfil certain functions for these social actors and provide certain stability and

order within the system. Rational institutionalism in international relations and international

political economy is strongly influenced by the theory transaction costs. The latter refers to the idea 20

that a certain arrangement (or contract) involves costs not only in terms of resources, but also in

terms of negotiating and enforcing it. Under these arrangements, institutions provide an opportunity

to lower “transaction costs” (Pierre et al., 2008). In other words, institutions serve to provide policy

channels, through which various actors can influence policy in order to maximize their own utility.

Frieden (2014) points out that institutional arrangements, political processes and social actors can 25

have considerable amount of influence over the choice of an exchange rate regime. This can be

attributed to the fact that economic and political actors will seek to maximize their own interests

through monetary policy. Furthermore, as Broz and Freden (2001) argue, the political regime and

the quality of the institutional arrangement. Yet, institutionalist analysis of exchange rate regime

choice has mostly been concentrated on non-crisis environments and the occurrence of currency 30

crises brings new implications due to increased political instability and economic uncertainty.


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Therefore, the aim of this dissertation is to address this gap and examine the choice of an

exchange rate regime in a post crisis environment in developing country. The research will focus

on a rational institutionalist analysis of the issue in order to examine whether the fear of floating

hypothesis still holds in a post-crisis episode and in what way the choice of an exchange rate regime

depends on domestic political actors and interest groups. Furthermore, the research will focus on a 5

case study analysis of the Asian financial crisis and on Thailand and Malaysia in particular. The

latter two countries are chosen to be analysed, as Thailand has had a functioning democracy, while

the Malaysian government has a distinctive authoritarian character, and thus this will allow the

research to uncover the extent to which a specific political regime influence the behaviour of

domestic actors in regards to exchange rate regime choice. The thesis will argue that the choice of 10

an exchange rate regime in developing countries in a post-crisis is dependent on the political

processes and institutional arrangements within any given state.

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) ‘’Favorable country 15

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 researched. 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 20

making process in regards to the choice exchange rate regime in a post-crisis environment.

Hypothesis 1 - The first hypothesis that will be proposed in this research is that the exchange rate

regime that a government in developing countries in a post crisis scenario will adopt is different

from the one that is initially announced or will be reluctant to let its currency float on the financial

markets (Diagram 1). Calvo and Reinhart (2000) refer to such behavior as a fear of floating and it 25

represents the reluctance of countries, and their respective governments to allow their currency 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


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developing countries, and the quality of their institutions. The first hypothesis then proposed that

the same behavior can be noticed even after the collapse of the currency.

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 5

groups have an interest to directly influence the choice of a de facto exchange rate, as they are

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 10

insulated against political domestic pressures, occurring after a crisis episode and as such they do

not need to depoliticize the issue. The second factor can be attributed to the lack of transparency

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 post-crisis scenario. 15

Diagram 1- Hypothesis 1


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2. Methodology and Structure of the Thesis

This thesis focuses on examining both primary and secondary data in order to address the

proposed hypothesis. The thesis will examine data and theories by scholars, academics and

professionals in journals, books and policy papers, and will combine them with quantitative data

from official reports form international institutions and organisations, such as the IMF, in order to 5

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 made. Cole et al.

(2005) argues qualitative data is suitable in examining the validity of already grounded theories and

employing quantitative data is beneficial in building upon these. The main method employed by

the thesis will be a combined pragmatic qualitative and quantitative method (Cole et al., 2005). 10

Using this method is suitable in analysing real world data and can be used in building up a logical

policy prediction (Liavari and Venable, 2009). Pragmatic research does not rely on specific research

philosophy but rather employs a mixed method approach to the research objectives in order to

examine the proposed problem in the most suitable and exhaustive way. By applying this research

design within the thesis, a certain amount of flexibility will be achieved, thus addressing the 15

research 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 policy is certainly dependent on a number of factors. Since pragmatist

design allows for the easy implementation of both qualitative and quantitative data, it will be most 20

suitable for addressing the issue of exchange rates as it can include a broad range of methods in

addressing the hypotheses (Liavari and Venable, 2009).

Primary data, will be implemented throughout the thesis in order to provide the arguments

with a solid background, based on primary research. The data will be gathered by examining official

statistics, administration papers and will be summarized within the text. The use of secondary data 25

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


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will be presenting a theoretical framework and argument based on established academic debates,

and then testing them against a case study 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 short introduction into the

topic, outlining both the hypotheses made and the methodology used in the presentation. Section 3 5

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 10

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 15

shown in the case studies, these theories can explain the choice of an exchange rate by a developing

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 rational of this

specific behaviour in regards to monetary policy by examining the political and economic effects

of currency devaluations. Furthermore, this section will examine the reasons why governments have 20

been behaving in this certain way. As such section 5 is crucial for 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 exist in academic

literature. While this does not address the hypotheses directly, this theoretical framework will be

useful in explaining the events in the case studies. In addition, this section will explain that the 25

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.

Then the thesis will focus on analysing the specific impact of interest groups on exchange rate

choice in developing countries. 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 30

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 authoritarian and

democratic political regimes. This analysis will be done based on the shortcomings of the specific

political system and the characteristics of the regimes, outlined in section 3. Finally, the thesis will

test Hypotheses 2 and 3 in section 9 by applying the theoretical framework provided earlier to two

case studies, namely Malaysia and Thailand, just prior and after the crisis. This section will examine 5

the way interest groups have influences the choice of a regime and will examine whether a

correlation exists in regards to the fear of floating behaviours. In addition, the case studies will also

examine how the nature of the political system fits in this model.

3. Exchange Rate Regimes

Choosing an exchange rate regime is a key macroeconomic policy and an important choice 10

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 and even attract capital (Levy-

Yeyati and Sturzenergger, 2003). This aim of this section is to classify the various exchange rates

in a way that has been examined and analysed 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 15

certain exchange rate 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 crisis situation in a particular country. Second, a number of research (Calvo

and Reinhart, 2002; Levy-Yeyati and Sturzenergger, 2003) have indicated that exchange rate

regimes can be identified in two ways: de jure and de facto. The former is based on the official 20

classification by the IMF and consists of exchange rates that have been declared by governments

themselves. This suggests that many countries announce an official exchange rate regime, but then

implement an actual exchange rate regime that differs from the official one. Ghosh et al. (2002; 8)

points out governments often run 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 25

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 hypothesis made, as it provides clarification on why developing countries might


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end up implementing an exchange rate regime, which is different from the one that is initially

announced.

3.1 Fixed Exchange Rates

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 5

balance between demand and supply for the currency. The main advantage of pegged exchange rate

regime is that offers 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 discipline monetary authorities, preventing them from pursuing inflationary policies. “ The logic 10

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 suggest that 15

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 also have a lower economic growth. These

implications are important for developing countries due to the fact that traditionally they suffer

from higher inflation rates and due to the fact that price stability offers them the chance to greatly 20

improve their trade with the country their currency has been anchored to. Furthermore, it seems that

pegged arrangements are very suitable to the manufacturing sector of tradable good, as the price

stability and the stronger trade relationship cause by the fixing of the real exchange rate serve to

stimulate the growth of such industries. Therefore, it can be expected that such industries will prefer

more stable monetary arrangements, which under the prism of political institutionalism implies that 25

they will try to influence policy in order to maximize their utility.

However, fixed exchange rates suffer from several crucial disadvantages. First, as giving up

exchange rates 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 5

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 10

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). 15

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 the technological advances means that in a world of globalized financial

markets, fixed exchange rates can be quite fragile (Setzer, 2006). The problem of over-borrowing

is defined by Palley as “a moral hazard, whereby agents think there is no currency risk associated 20

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. a debt inflation. Keeping in 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 rates offer an 25

economic policy tool that can help them to in dealing with inflation, establishing stable trade

relations with developed countries by pegging the exchange rate to their currency and ensuring

price stability. However, the anti-inflation policy and the price stability come at a price that a

country with insufficient foreign reserves and low trade balance may be unable to address (Palley,

2003). 30


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3.2 Flexible Exchange Rates

Theory and empirical analysis point out that fixing the exchange rate to either another

currency, the dollar or a commodity like gold, really does lead to an increase in international trade

and investment levels, and disciplines the monetary authority of the country that has adopted it

(Broz and Frieden, 2001). However, the problems that are normally identified with pegged regimes 5

have been a source for a lot of debates in the field of economics. The alternative has been

traditionally identified as undertaking a floating exchange rate regime. The main argument in favour

of such a regime has been best described by Milton Friedman (1953) who argues that if domestic

prices adjust slowly, it is more “cost effective” to move the 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 10

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 rates are a better option in 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 15

due to a combination of political and economic factors are better off pegging their exchange rates.

This can indicate that developing 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 20

developing countries fall in the former category, they are likely to prefer a pegged exchange rate.

“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 25

monetary policy in other countries (Bernhard et al. 2002; 708).”

In other words, in times when capital mobility is of upmost 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


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and external shocks. In addition, it also allows for monetary policy to be set independently in

accordance to the domestic context of a given country (Bernhard et al., 2002).

Another advantage of floating exchange rate is that the flexibility it offers can be extremely

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, 5

harming the competitiveness and the balance of payments (Edwards and Savastano, 1999). “When

residual (or demand) inflation generates an inflation differential between the pegging country and

the anchor, it induces a real appreciation that, in the absence of compensating productivity gains,

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 10

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 lender-

of-last resort” (McDonald, 2007; 31) In other word, central banks can finance governments through

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. 15

The first problem refers to the fact that without a peg central banks might pursue policies that are

in effect inflationary (Hausman, 1999). As such the floating exchange rate regime fails to discipline

the money authorities and therefore lead to inflation. Kamin (1997) for example clearly shows that

higher exchange rate flexibility is related with higher inflation. The problem is most prominent for

developing countries, which have been plagued by poor levels of economic development and high 20

inflation. Due to these facts, rapid capital inflows and outflows can lead to a high volatility, which

in turn leads to higher inflation. In addition, increasing inadequately the money supply in circulation

by the central bank, as well financing the government’s need by printing money, creates further

dangers of inflation (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 25

in the exchange rate (Esaka, 2010). “Misalignment occurs because exchange 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 30


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exchange rate regimes lies with the so-called peso problem. This issue is associated with lack

credibility on financial markets, amongst foreign investors and amongst the public mainly 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).” 5

3.3 The Economic Trilemma and Exchange Rates

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 10

trilemma is illustrated in the triangle in Figure 1 and each one of the sides of the figure represents

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 15

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 20

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).


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Figure 1 – The Impossible Trilemma; Source: Aizenman and Ito (2013)

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 5

dilemma as countries seek to attract outside capital under the form of FDI or seek to have better

access to foreign capital, through credit (Obstfeld et al., 2004). Essentially this means that the trade-

off is between exchange rate fixity and domestic macroeconomic stability. In case of the former,

losing independent monetary policy essentially means giving up a crucial policy tool in dealing

with recessions, which operates on the idea that the central bank can manage the supply of money 10

and monetary expansion essentially reduces interest rates. Furthermore, the fact that fixed exchange

rate regimes are extremely prone to speculative attacks, especially under inconsistent government

policy and budget deficits, means that the economy of the country is prone to a recession, if “bad”

policy is pursued. Control over inflation and price stability offered by a flexible exchange rate

through independent monetary policy often represents an enticing option to developing countries, 15

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.

A major contribution to this model has been proposed by Mundell (1963), who has analysed 20

how the trilemma develops in a small country that is supposed to choose its exchange rate regime


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and the levels of capital mobility. As it is pointed out by Aizenman (2010), this model is rather

simplified as it considers only two polarized binary choices in regards to the exchange rate regime,

but it illustrates their implications rather well. Under a capital mobility and fixed exchange rate

regime, and assuming that foreign government bonds are of equal price with domestic bonds,

increase in the money supply by the central bank will put downward pressure on the domestic 5

interest rates and will trigger the sale of domestic bonds, since investors will seek the higher yield

offered by foreign bonds (Obstfeld et al., 2004). Therefore, the central bank will have to intervene

in the currency market in order to satisfy the demand for foreign currency, using its reserves to buy

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 10

of the money supply, which passively adjusts to the money demand. Thus, the policy configuration

of prefect capital mobility and fixed exchange rate implies giving up monetary policy (Aizenman,

2010; 5). The implication is that the domestic interest rate is determined and affected by the 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 15

monetary autonomy, can preserve the mobility of capital. “Under a flexible exchanger rate regime,

expansion of the domestic money supply reduces the interest rate, resulting in capital outflows in

search of the higher foreign yield. The incipient excess demand for foreign currency depreciates

the exchange rate (Aizenman, 2010; 4).” If a higher supply of money is introduced in the economy,

the interest rate is reduced, which improves domestic investments and reduces the exchange rate of 20

the domestic currency. This in turn increases net exports, but also means that a country loses its

exchange rate stability. The problem with this policy is that rapid capital inflows and outflows can

destabilize the economy as the loss of exchange rate stability can lead to higher inflation rates. This

represents a significant problem for developing countries, which traditionally have suffered from

high rates of inflations and therefore monetary stability has been seen as a way to counter this 25

problem (Setzer, 2006). However, in reality countries have experimented with limited capital

mobility or various degree of financial integration, and central banks have been involved in

managing the exchange rate in an attempt to reap the benefits of all three of the possible dilemma

choices (Aizenman, 2010). Furthermore, the credibility of a fixed exchange rate can be in a flux,

which means that central banks must actively support it or change under certain external or internal 30

pressures, such as speculative attack. Keeping in mind these implications, it can be argued that the


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economic trilemma poses an important question regarding the exchange rate choice and the overall

macroeconomic policy framework of a given country.

3.3 Intermediary Exchange Rates

Real world examples often indicate that a simple two-way distinction is too simplistic and

governments have used regimes that do not strictly fall into one of the two categories, which 5

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 policy (Bubula and Okter-Robe, 2002).

In this regard, a study conducted by Bubula and Okter-Robe (2002) discover that the both

classifications do not reveal the full picture in regards do exchange rates. Between 1975 and 1998

the IMF has based its classification on two notifications (Diagram 2): 1) official notification by a 10

particular country within 30 days of becoming a member of the IMF and 2) any changes in the rate

after that (Bubula and Okter-Robe, 2002). The classification proposed by the IMF has led to four

major exchange rate categories, namely pegged regimes, flexible regimes, regimes with limited

flexibility and other managed arrangements. Each one of these major categories had a total number

of 9 subcategories. 15

Diagram 2 IMF Exchange Rate Classification - Source: Habermeier et al. (2009)

1998 IMF De Facto Exchange

rate classification

Hard Pegs

Arrangements with no separate

legal tender

Currency board arrangements

Soft Pegs

Intermediate pegs

Pegged exchange rate with

horizontal bands

Crawling peg

Crawling bandConventional fixed peg

Floating Arrangements

Managed floating

Indepently floating

Other Managed arrangements


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Based on their finding, Bubula and Okter-Robe (2002) argue that due to the increased

capital mobility and the desire to preserve independent monetary policy countries have sought to

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 5

announces, i.e. the jure regime. Based on their findings they identify twelve actual exchange rates:

“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 10

exchange rate within crawling band”; “backward pegged exchange rate within crawling band”;

“tightly managed float”; “other management floating with no predetermined path for the exchange

rate; and independently floating” (Diagram 3). Although these can be roughly classified in the three

main categories, their sheer number suggests that governments have sought for a way to undertake

an exchange rate that combines both of the positive qualities of pegged and flexible exchange rates. 15

The main rationale behind this is attempting to reconcile the impossible trinity under capital

mobility, i.e. achieving both exchange rate stability and independent monetary policy. A similar

classification is used by Levy and Sturzenegger (2002) who argue that the IMF classification has

proven to be incorrect and classify the regimes as flexible, intermediate or fixed. By using a cluster

analysis Levy and Sturzenegger (2002) conclude that currencies with high exchange rate volatility 20

and little market intervention are considered floating. On the other hand, a fixed exchange rate is

considered to be one where volatility is small but central bank reserves are high. Finally, an

intermediate exchange rate can be attributed with moderate volatility and moderate to high

exchange rate interventionism by the central bank. In fact, Ghosh and Ostry (2009) argue that

growth performance is best achieved under intermediate exchange rate regimes, as they are 25

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 rage regimes as their de facto

monetary arrangements.


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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 broad notion of crawling peg. It is generally expected that his regime represents a system of

adjustments in which a particular fixed exchange rate regime is allowed to fluctuate within specific 5

band (Bubula and Okter-Robe, 2002). The bands themselves are also subject to adjustments

depending on the targeted inflation, or the inflation differentiations with trading partners. In

De facto Classification of Exchange Rates

(Bubula and Okter Robe 2002)

Intermediate Regimes

Tightly Managed floats

Soft Pegs

Crawling bands

Backward looking

Forward looking

Crawling pegs

Backward looking

Forward looking

Conventional fixed pegs

Vis-a-vis a single currency

Vis a vis a basket

Hard Pegs Regimes

Currency board arrangement

No separate legal Tender

Formal dollarization

Currency Union

Floating Regimes

Indepentently floating

Other managed float with no predermined exchange rate path


23 | P a g e

addition, the rate can either serve as an anchor which is a forward crawling peg or backward

crawling peg, when the rate is aimed at “generating inflation adjustment changes (Bubula and

Okter-Robe, 2002). This points out to the fact that intermediate exchange rates have been developed

as a solution of the impossible trinity (Setzer, 2006). In a world characterized by interconnected

world markets, financial institutions and globalized economies, it is crucial to preserve capital 5

mobility, as it offers easier access to FDI, portfolio investments and increases the amounts of

investments. Wagner (2000) argues that this is especially true when it comes to the economies of

developing countries who seek easy access to foreign capital under the form of loans or to FDI.

According to him, however, developing countries benefit from capital mobility only if they have

reached a certain degree of development. If capital mobility is chosen, then a developing country 10

has to choose between having an independent monetary policy or a stable exchange rate regime. As

such the intermediary exchange rate is a way to seek compromise between the two, by both aiming

at achieving a stable exchange rate and a limited monetary policy independence (Setzer, 2006).

However, these exchange rate regimes suffer from one important problem- according to the

Wyplozs (1998) these currencies are extremely vulnerable to the second generation currency crises 15

models, namely investors are not sure about the government’s commitment to a peg. Therefore,

even though a full equilibrium may exist in the form of a consistent policy towards to exchange rate

commitment, speculative attacks might occur due to the inability of private financial actors to

determine the level of commitment of the government to a peg. In addition, Krugman (1999)

maintains that finding such a compromise might be difficult simply because of the fact that the 20

impossible economic trinity obstructs it.

4. Exchange Rate Theories and Developing

Countries

Having outlined the characteristics of the various exchange rate regimes is it important to

briefly outline what are their implications for developing countries. Each of these regimes have 25

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


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inappropriate policy is pursued. International investors who are suspicious of the ability of country

to defend the peg can launch a speculative attack which might result in a forced devaluation

(MacDonald, 2007). Flexible exchange rates on other hand do not suffer from that problem and

they are easily reconciled with the idea of capital mobility (Cardoso and Galal, 2006). Considering

the fact that most emerging markets seek to attract capital and FDI in order to fuel their development 5

it can be logical to assume that flexible exchange rates are better suited to the context of capital

mobility. However, the implications of floating exchange rates for developing countries have been

considered to be severe (Setzer, 2006). This can be attributed to several reasons, the first one being

that developing countries suffer from relatively high inflation. Therefore, governments in such

countries are eager to establish a system that stabilizes this aspect of the economy (Poirson, 2001). 10

In addition, keeping a relatively devalued currency can help in maintaining a relative amount of

competitiveness, especially if the country seeks to develop its export sector. Another problem of

developing countries is the fact that their political and governance systems are often perceived to

be inadequate, and as such large currency fluctuations on financial markets can be expected (Broz

and Frieden, 2001). The following sections will examine a few core theories that have described 15

how a country chooses its exchange rate. This will help to explain the rationale behind the choice

of exchange rate regimes implemented by developing countries and will be useful in analysing the

exchange rate regimes in a post crisis scenario.

4.1 Mundell-Fleming Framework

A crucial theory that deals with the economic trilemma and exchange rate regimes under a 20

full capital mobility is Mundell-Flemming Framework (Fleming, 1962; Mundell, 1963). In effect

the theory focuses on the nature of the shocks that the economy faces. According to Poole (1970)

there are two types of shocks that can predetermine the best optimal currency choice- nominal

shocks, which mainly originate in the domestic financial and monetary system, and real shocks,

that begin in the goods market. The exchange rate regime choice depends on which types of shocks 25

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


25 | P a g e

Poole (1970) allowing the nominal exchange rate to fluctuate can serve as an adjustment mechanism

in order to create the needed international price changes, unlike fixed exchange rates.

Furthermore, the Mundell-Flemming framework follows the Keynesian tradition, in which

aggregate supply takes the passive role of fixing the price level, while variations in aggregate

demand is what determines the level of economy activity (Copeland, 2005). The model examines 5

the relationship between economic output and the nominal exchange rate in an open economy in

the short run. The framework has been used as an argument to support the impossible trilemma, in

1which a government cannot simultaneously maintain exchange rate stability, independent

monetary policy and free capital movement (Young et al., 2004). The Mundell-Fleming model

provides an analysis of small open economies under a fixed or floating exchange rate. In the latter 10

case, an increase of government spending will drive the IS (investment-savings curve, of which

government spending is a part) upwards, which will increase the exchange rate, hurt exports and

diminish the effect of the government spending (Graph 1) (Copeland, 2005). On the other hand,

increase in the monetary supply will drive the LM (liquidity-money supply curve) right, which

results in lower exchange rate and higher economic output (Graph 2). Under a fixed exchange rate 15

regime, however, the increased government spending will raise the IS curve upwards, which will

potentially increase the real exchange rate. Therefore, the central bank must increase the monetary

supply in order to keep the peg (Graph 3). However, under a fixed peg, the central bank is unable

to do conduct an independent monetary policy, as any increase of the money supply may result in

a collapse of the exchange rate regime. 20


26 | P a g e

Graph 1; Source: Sanders (2008; 2) Mundell Fleming

Framework: Increase in government spending-

Floating Exchange Rate Regime

Graph 2; Source: Sanders (2008;3) Mundell Fleming 5

Framework : Increase in Monetary Supply- Floating

Exchange Rate Regime

Graph 3; Source: Sanders (2008; 4) Mundell-Fleming

Framework: Increase in Monetary Supply under a 10

fixed Exchange Rate Regime

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 15

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


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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 high-

powered money in circulation, which compensates for the shift in money demand, thereby

insulating the domestic economy from the original shock (Setzer, 2006; 16).” Finally, according to

the Mundell-Flemming approach an intermediate exchange rate regime is suitable to countries that 5

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 10

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 15

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 20

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 25

account that 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


2 | P a g e

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

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 5

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 10

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 implication for 15

the MF model discussed earlier, as under a form of capital control an increase in government

spending or 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 20

it comes to stabilizing the exchange rate regime (Kaplan and Rodrik, 2011).

4.4 Exchange Rate Regime Choice for Developing Countries-

Towards an Institutionalist Approach

25

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


3 | P a g e

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

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 5

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 10

limited links to international capital markets, less diversified production and exports, and shallow

financial markets, as well as countries stabilizing 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 15

countries with relatively stronger financial sector and have been attributed with 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 20

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 pegged exchange rate regime

increases 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 25

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 in the face of a currency crises and

recent devaluation, in which developing countries are forced to adopt a more flexible exchange rate. 30

Yagci’s (2001) arguments point out to a strong relationship between political and economic factors,


4 | P a g e

when it comes to choosing a suitable exchange rate regime. Therefore, variables, such as the

stability and quality of institutional arrangements, do play a role in the process.

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 5

plays 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, 10

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 15

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 20

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 25

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.


5 | P a g e

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 5

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. 10

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 15

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 the 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 20

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 25

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.


6 | P a g e

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 5

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 suggest 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 10

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, 15

2000; 65).” The second one suggest 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 holds true under full employment. Since the unemployment is usually high in the case of 20

developing countries, this means that the first outcome will be unlikely and therefore, the overall

effect of the devaluation will be contractionary.


7 | P a g e

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, 5

thereby lowering imports and stimulating the demand for exports and non-tradable goods, the short

term effects of the devaluation can have 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 10

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 15

Rational economic actors would anticipate the longer term effects of devaluation that

encourage export and as such they should be hesitant to punish politicians (Frankel, 2004).

However, the immediate negative effects such as increase in unemployment and reduced output

suggest that the expectation for 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 20


8 | P a g e

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; 5

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 10

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 15

inconsistency, and transaction risks between liabilities and assets or borrowing in a foreign

currency, creating 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 20

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 25

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 30


9 | P a g e

(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 5

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 10

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 15

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 20

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 25

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 30

they can fix to an undisclosed basket of currencies. “Such an arrangement enables the authorities


10 | P a g e

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).

5.4 Fear of Floating

Considering the political and economic costs of devaluation, it can be easily argued that 5

governments in developing countries will try to prevent devaluations. Taking in 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 reduction in the 10

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, 15

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 20

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,

capital flows and trade, and as such government 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 25

credibility and as such they will behave according to the “fear of floating” model. In addition,

exchange rate swings and higher inflation is 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)


11 | P a g e

Calvo and Reinhard (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. 5

However, it must also be pointed out that developing countries are not relying solely on exchange

rate regime manipulation but also on monetary policy. “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 10

argument that the implementation of de facto intermediary exchange rate regimes under capital

mobility, combined by monetary policy as an economic tool, have 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 15

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 crisis-

period. 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. 20

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

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 25

arrangements and political relations between the different actors to influence the de facto choice of

an exchange rate regime.


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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 5

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 10

in the current global economy currency crisis 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 15

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 for foreign currency. This in 20

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

eliminates the lasting foreign exchange reserves and leads to the abandonment of the fixed exchange

rate (Miguez- Alfonso, 2007; 87).” 25

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


13 | P a g e

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: 5

“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 10

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 15

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. 20

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 neverhteless (Hefeker, 2000). These

findings fit in the ‘fear of floating’ behavior and as it will be argued later has further implication

even after the devaluation has already occurred. The implication of the first generation model of 25

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


14 | P a g e

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 5

attacks can occur even while the government policy is consistent with the peg. Under this model,

the government and the central bank is 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 10

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 15

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, 20

economic agents might expect a loosening of the monetary policy due to the higher cost of

defending the peg. This again can lead to a speculative attack by economic actors who anticipate

change in policy.

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. 25

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


15 | P a g e

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 crisis 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 5

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 10

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. 15

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 20

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 25

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.


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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 5

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. 10

The third generation model takes these two factor in 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 15

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 long-

term 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 20

(1998) for example argue that the over borrowing of 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 policy to cover

their debts by using taxation as a source of capital. Burnside et al. (2001) supports this theory and 25

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


17 | P a g e

are 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 5

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 10

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 final point 15

that must be outlined and is typical of the third crises

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 20

issues. This is based on the idea that external shock such, as the increase in foreign interest rate

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 25

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


18 | P a g e

to bail-out financial institutions demands the creation of more money. However, by printing out

money the government eventually causes 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). 5

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 of 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, 10

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 boon has

been financed with external credit. This surge in back credit eventually results in an outflow of 15

capital and crash of the assets market, which causes a shock on 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 20

by the role of the banks and how these can result in an exaggerated business cycles, which lead to

financial crises and currency crises.


19 | P a g e

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 5

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 10

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 15

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 characteristic 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 20

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 25

access to capital. Political culture has played a large role in the events as well, due to the fact that


20 | P a g e

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 5

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 10

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, 15

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 20

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 25

any other free-floating currency. Table 1 provides 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. 5

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 10

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). 15

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 20


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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 to 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 5

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 10

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 15

series of speculative attacks followed, during which investors sold off their Thai baht denominated

assets (Hale, 2011). The baht fell by 16% in the same day and as Hale (2011) points out, it lost over

50% of its value by 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 to these countries simply 20

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 25

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


23 | P a g e

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 5

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 forces 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 10

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

Jure

Pre-Crisis- De

Facto

Post-Crisis: After 1997

De jure

Indonesia Managed Floating Fixed Independently Floating

Philippines Independently

Floating

Managed

Floating

Independently Floating

Thailand Fixed Fixed Independently Floating

Malaysia Fixed

Managed Floating

Pegged

Arrangement

Pegged Arrangement

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 15

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


24 | P a g e

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 5

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 10

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. 15

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 considerable amount of flexibility is observed in the post-crisis economic

environment, as shown in Table 3 (Hernandez and Montiel, 2001). The table represent data that has

been collected by the IMF and as such it suggests that the de facto exchange rate announced by 20

these country is 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 grey), 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 hypotheses made by this thesis is incorrect. 25


25 | P a g e

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 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 5

(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 10

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,

-200.00%

0.00%

200.00%

400.00%

600.00%

10

/1/1

99

4

1/1

/19

95

4/1

/19

95

7/1

/19

95

10

/1/1

99

5

1/1

/19

96

4/1

/19

96

7/1

/19

96

10

/1/1

99

6

1/1

/19

97

4/1

/19

97

7/1

/19

97

10

/1/1

99

7

1/1

/19

98

4/1

/19

98

7/1

/19

98

10

/1/1

99

8

1/1

/19

99

4/1

/19

99

7/1

/19

99

10

/1/1

99

9

1/1

/20

00

4/1

/20

00

7/1

/20

00

10

/1/2

00

0

1/1

/20

01

4/1

/20

01

7/1

/20

01

Chart Title

USD/THB USD/MYR USD/PHP USD/IDR


26 | P a g e

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 5

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 impemented. 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 10

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

Indonesia Pre-crisis 2.038 3.086


Philippines Pre-crisis 3.859 4.479


Thailand Pre-crisis 1.850 2.927


Malaysia Pre-crisis 2.118 2.803

Post-Crisis 2.643 3.183

Table 4- Monthly Reserve Volatility; Source: IMF Hernandez and Montiel 2001


27 | P a g e

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 5

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 10

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, 15

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 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 20

the pure float and the hard peg (Fischer, 2001). Willet (2005) argues that the Bretton-Woods system

has showed that adjustable pegs are highly prone to currency crises in light of high-capital mobility.

This represents an important problem for developing countries which are basically trying to attract

capital. 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 25

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 argue that such policies are not

unsustainable (McKinnon and Ronald, 2002, and Combes et al., 2011). Willet (2005) also concedes 30

this point and argues that for some developing countries de facto regimes that contradict the official


28 | P a g e

de jure regimes are not problematic and for example crawling peg has worked relatively well on

several 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 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 5

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 represent 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 10

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 15

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 20

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 25

rate regime.


29 | P a g e

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 behaviour in a post-

crisis episode and the implementation of an exchange rate regime, different from the initially 5

announce 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 regime

(Hefeker, 1997). This can be explained by the fact that states, economic agents and political actors 10

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 favourable domestic environment that will support the peg,

regardless of the costs involved (Setzer, 2006). If popular support is low, then the credibility of 15

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 of 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 20

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 25

of a particular regime will not be felt the same across all industries, which can basically create

both “losers” and “winners”.


30 | P a g e

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 form 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 5

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. 10

In a traditional democracy, policy makers will have to pursue the policies that are of interest to

politically powerful and strategically imporant groups as they otherwise risk an electoral defeat. “A

country's exchange rate policy is then a combination of each sector's preferences 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 15

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 20

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 rates prevent currency fluctuations and as such investment and trade can be 25

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 degree to which they are involved in either domestic or


31 | P a g e

international economic activity. Therefore, it can be concluded that groups that are involved in

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 5

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. In addition,

derivatives often provide a bail out clause or are simply impossible to as the precise pricing can be

impossible (De Grauwe and de Bellefroid, 1987). In addition, Hefeker (1996) argues that models 10

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 15

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 20

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 Favour of Flexible Exchange Rate Regimes

The same approach can be employed when considering which interest groups are most 25

likely to favor flexible exchange rates. As it was argued earlier, floating or flexible exchange rate

regimes are less prone to speculation 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


32 | P a g e

favored by the non-tradable industries and import companies of tradable goods, as they are less

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 5

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 10

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). 15

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 20

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 provids 25

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 tend to manipulate 30

the exchange rate regime before elections in order to create perception of improving socio-


33 | P a g e

economic conditions amongst the electorate. This points out that the consumers do have a 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.

8.3Authoritarian Vs Democratic Regimes

Another important aspect of the political economy of exchange rates is the specific type of 5

the government and the political regime. This plays a role both in the choice of exchange rate regime

and the willingness of the government to devalue. 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 10

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

the foreign reserves in order to create a sense of stability in an attempt to appease the most 15

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 20

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 25

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


34 | P a g e

rate regime. Therefore, authoritarian regimes will prefer to implement a pegged exchange rate

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 has

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 5

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 10

transparency makes pegged exchange rate regimes more attractive to authoritarian governments, as

policy-makers perceive it as 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 by the political effects of interest 15

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, since developing countries suffer from high level of 20

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 loss of 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 25

relatively well insulated against domestic interest group. Therefore, governments will be reluctant

to let its currency float on the financial markets in an attempt to retain their credibility. Finally, as

fixed exchange rates and price stability offer the establishment of more stable trade relations with

more 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). 30


35 | P a g e

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 5

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, 10

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 15

further (Steinberg et al., 2015). However, democracies do not usually suffer from the lack of

credibility and transparency that can be attributed to authoritarian regime 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 is a combination of electoral

and legislative institutions and these can affect the preferences of politicians and policy makers in 20

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 25

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 30


36 | P a g e

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 5

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 suffer from poor institutional arrangement and weak governments, 10

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, 15

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 20

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 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 25

such, democracies inherently do not need a fixed regime in order to enhance their credibility. Yet,

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


37 | P a g e

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, 5

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 governments’

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 10

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 15

situation and helps them anticipate the reactions of the government in terms of policy.

These findings naturally have an impact for exchange rates 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 20

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 export-

oriented 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 25

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 30


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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 5

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 government

(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 10

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,

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 15

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 20

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 attribute to the preferences of specific interest groups, such as the manufacturing

sector and the political elites. Furthermore, political uncertainty, instability, the quality of the 25

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 abandoned practically in favour of a more managed one as a

direct result of both economic and political concerns. However, authoritarian regimes will be more 30


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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 5

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 10

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 15

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. 20

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 new political era for the country (Hicken,

2009). On the other hand, Malaysian political regime is regarded as having authoritarian

characteristics. “If the crisis generated political change in Malaysia, it appeared to be in the direction 25

of increasing concentration of authority in the hands of the prime minister and creeping

authoritarianism (Haggard, 2000; 107).” As such Malaysia and Thailand represent a good


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opportunity to examine closer 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 5

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 10

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 15

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 20

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).” 25


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Graph 5- Souce: 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 5

exports became relatively more expansive 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 10

of Banharn to collapse in 1996 (Hicken 1998). The new government was headed by Chavalit and

his New Aspiration Party, and was compromised by 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 15

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 20


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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 5

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 5

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 10

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). 15

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, the programme has alarmed

the financial markets “that further decline was in store, contributed to the overshooting of exchange 20

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 of

the economic collapse. The constitution involved 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 25

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 markets and the international financial institutions, Thai politics

reverted to intercoalitional conflicts (Haggard, 2000; 94).” In addition, as it was shown earlier, 30


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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 5

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 10

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 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 15

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 20

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 25

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 for the economic

development of the country (Satitniramai, 2007). In addition, the liberalization process


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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 5

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 10

in check.

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 15

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 characteristic of this 20

Country Ownership

Concentration in

10 largest firms

(3 largest

shareholders)

Share of total

outstanding shares

owned by 5 largest

shareholders

Share of total market

capitalization

controlled by top 15

families

Market share of five

largest banking

institutions, end-

1997 (share of bank

loans)

Share of firms unable

to cover interest

expenses from

operational cash flow

(peak number and

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)


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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 the showed that his issue 5

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, 10

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 15

supported by the data in Table 5 and by the direct involvement of the export and 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 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 20

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 political influence of interest groups. In this sense, one should expect that 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 25

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 easy to see why the Thai baht was fixed

to the dollar. In addition, the Thai export sector and political had perceived the peg as way to 30


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increase economic activity 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 country explains

why the political system was basically captured by the private sector. In addition, according to the 5

theoretical model described earlier, since development countries lack political credibility, which

can potentially increase their exchange rate volatility, they will be likely to favour 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 10

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 15

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 20

for the constitution which resulted in a protest of business representatives in an actual support of

the constitutional reform. However, as Haggard (2000) outlines, the reform never did address the

fact that the political system was in effect penetrated by individuals who were both politicians and

large businessmen. Another problem, however, derives straight from the fact that Thai political

economic system was largely reliant on FDI flows in its development (Amar, 2011). While this is 25

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.


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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 5

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 10

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 15

of foreign direct investments (Ammar, 1997). In addition, although such actions were sanctioned

by the IMF, with every new letter of Intent by 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 20

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 25

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 large influence on the government’s policy. In terms of

exchange rates, 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. 30

Based on these developments, one can safely argue that the new Thai government simply took the


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middle road. In its officially exchange rate, 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 5

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 explain 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) 10

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 15

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 20

(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 25

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


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put comprehensive regulation on 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 attempts

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 5

collapse, although regional contagion has been instrumental to 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 10

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 15

“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


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a massive capital outflows (Haggard, 2000). This in turn made the banking sector experience non-

performing 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 5

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 investments 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 10

FDI inflows to the country diminished significantly. The result was and eventual collapse which

lead 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 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 15

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 20

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 25

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 30

Malaysian politics is illustrated in Graph 8, with score 0 being the best possible and score 100 being


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the worst possible. The graph indicates poor quality Malaysian governance in all variableс,

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, 5

with both being highly regulated by government institutions, which created further concerns

amongst foreign investors about policy transparency (Jomo, 2003). In addition, 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.

10

Graph 8 - Source: World Bank

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

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, 15


53 | P a g e

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 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 5

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 10

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” 15

(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 20

impossible to keep running will 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 25

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

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.


54 | P a g e

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 point out to 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 5

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 10

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). 15

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 20

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. NEP

and the NDP were criticized for their ethnocentric character and for their preferential approach. In 25

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 of

public owned enterprises and infrastructure were 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 30


55 | P a g e

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 5

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 ethnocentric approach to both macroeconomic and microeconomic policy

underlined the importance of this actor in the overall policy strategy of the authorities. This also

explain why a peg was considered to be more adequate for the NEP and the NDP. Table 5 confirms 10

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 15

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 20

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 25

(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, to social activists, grassroots organizations, and NGOs

seeking to capitalize on the crisis (Case, 1999; 6-7).” The protests were, however, successfully

supressed by the government and Mahatir, who realizing that the opposition is becoming more 30


56 | P a g e

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 more

tight political and economic control in the hands of a small elite, which can be explained by an 5

attempt of 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

have had low impact on monetary policy, which fits in the institutionalist analysis provided in this 10

research. In addition, the financial sector, which was in effect controlled by the Malaysian

government and was heavily regulated, was unable to influence policy exchange rate to any

significant degree due to its interdependency with the authorities. Furthermore, while the country

had experiences 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 15

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 20

is well illustrated by the fact that Mahatir resumed support and direct involvement on a number of

public and private companies (Hasan, 2002). Even though the government 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 25

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

reveal that authoritarian governments in developing countries are also likely to be reluctance to let 30

their governments to float (Jomo, 2003). In addition, the Malaysian government simply did not


57 | P a g e

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 5

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 does 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 10

influence policy through the use of the established political system. In fact, since a currency crisis

can cause significant amount of political instability, interest groups will be even more proactive in

their attempts to lead 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 15

leads to the conclusion, that the very arrangement of domestic political institutions has a significant

impact on how interest groups behave and influence 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 20

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 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 25

even though the debate has been often introduced as a change between a peg and a float, research

points out that wide variety of monetary arrangements exist. As the research has argued, the

emergence of intermediately exchange rate arrangements represent an attempt to reconcile the

impossible trinity of economics. This type of monetary policy has been increasingly implemented


58 | P a g e

by developing countries, as the liberalization of markets and the need to attract investment has put

pressure on their currency. 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 5

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 plays a role when it comes to investor’s trust.

Research, however, points out that there is a clear misalignment between the officially announced 10

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 maintain monetary policy independence.

However, economic policy inconsistencies can cause severe currency crises, which not only 15

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 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 20

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, has 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 25

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

development states, as the usually low political stability is undermined even further by 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 30

imports, the general public, financial institutions and the manufacturing sector, regardless of the


59 | P a g e

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 regards to an exchange rate

regime by developing countries in post-crisis environment has not been addresses to a large extent

in economic literature. Even though earlier research has sought to examine the issue, findings have 5

remained rather limited. This thesis has sought to address this research gap and has therefore

examined the behavior of developing countries in regards to the choice of an exchange rate regime

in developing countries immediately after a crisis episode. The correlation between the 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 10

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 in this regard: 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;

and the political arrangements in terms of a democratic versus authoritarian regime characteristics 15

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 20

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 of their social interaction, the latter will also seek to satisfy its own political goals.

Based on the data presented in section VII on Asian financial crisis, the thesis has concluded 25

that after a crisis period, developing countries are likely to continue to manipulate the 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 crises and the collapse of the real exchange rate, developing countries will still 30


60 | P a g e

behave as described by the fear of floating hypothesis. While this can be partially attributed to

economic concerns, such as price stability, monetary volatility and trade stability, the research has

argued that a key reason for the fear of floating behaviour can be attributed to the specific political

process within developing countries and their respective institutional arrangements. In the case of

Thailand, for example, this was done due to the political instability of the country, caused by the 5

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 in

the hand of a small elite, the government continued to manage the exchange rate regime in order to 10

address the concerns of the political and economic actors, that were perceived to be of strategic

importance (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. In this particular 15

scenario the government can be perceived as both an agent and a principle actor. On the hand, the

new Thai government wanted 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 20

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 to float

on the financial markets. Unlike the former, however, Malaysia had officially implemented a fixed

regime prior to the crisis and retained a de jure peg after the economic collapse, which can be 25

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 30

proposed “IMF approach to the crisis”, which called for a higher levels of liberalization, was not


61 | P a g e

considered in line with the NEP policy, pursued by the authorities and favoured by the highly-

ethnocentric 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 5

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 10

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 15

shows that authoritarian regimes are reluctant to let their currency float.

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. However, the

thesis is not without its limitations and while it does provide a theoretical foundation for future 20

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 political process 25

can have a significant impact on policies that are not traditionally a subject of public sphere debates.


62 | P a g e

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thesis- martin belchev- exchange rate regime choice in developing countries

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