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.............................................................................................105
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.............................................................................................................2010
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 ..........................................................................................................................................515
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.......................................................1220
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.........1925
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 ......................................................................................................................................................2930
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 .....................................................................................................395
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 ....................................................................4710
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: ........................................................................................................................................6215
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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 lead5
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 in10
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
20
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 by5
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 upmost15
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 economic20
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 fields25
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 which5
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 domestic10
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 liberalization15
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 let20
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 countries25
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 issue30

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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 a15
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 idea20
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 can25
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 currency30
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 a5
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 of10
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 country15
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 decision20
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 it25
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 interest5
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 better10
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 to5
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 the15
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 most20
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 data25
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 35
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 grounds10
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 be15
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 have20
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 the25
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 section30
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 examine5
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 choice10
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 a15
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 official20
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 expanding25
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 the5
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 logic10
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 that15
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 greatly20
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 that25
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 the5
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 respective10
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 associated20
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 an25
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 regimes5
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 the10
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 volatility15
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, since20
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 to25
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 and10
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 high20
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 misalignment25
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 floating30

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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). The10
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 policy15
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 the20
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 a5
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 money10
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 analysed20
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 domestic5
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 control10
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 its15
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 of20
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 this25
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 internal30
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, which5
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 a10
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 officially5
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 pegged10
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 volatility20
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 are25
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 specific5
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 capital5
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 country10
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 crises15
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 the20
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 have25
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 development5
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 described15
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 a20
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 shocks25
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 examines5
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 latter10
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 rate15
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 Fleming5
Framework : Increase in Monetary Supply- Floating
Exchange Rate Regime
Graph 3; Source: Sanders (2008; 4) Mundell-Fleming
Framework: Increase in Monetary Supply under a10
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 the15
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

1 | P a g e
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 that5
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 of10
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 speculative15
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 rate20
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 into25
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 it5
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 partial10
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 for15
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 when20
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 other5
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 with10
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 developing15
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 a20
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 crisis25
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 trade5
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 be15
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 makes20
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 exchange25
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). The5
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 trade15
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 major20
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 damaging25
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 to5
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 results10
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 of20
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 consumers10
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 Devaluations15
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 avoid20

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 the10
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 maturity15
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. This20
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 the25
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 Edwards30

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 country5
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 in10
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 incurs15
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 as20
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. In25
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 that30
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 that5
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 the10
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 two20
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 retaining25
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 the10
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 behavior15
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 institutional25
arrangements and political relations between the different actors to influence the de facto choice of
an exchange rate regime.

12 | P a g e
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 of5
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 that10
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 to15
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 in20
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 these10
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 some15
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 of25
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 speculative5
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 credibility10
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 their15
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

Thesis- Martin Belchev- Exchange Rate Regime Choice in Developing Countries

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