The political and institutional sources of exchange-rate regime choices in middle-income developing countries (Thailand, Mexico, Colombia)

With a pegged exchange rate, a government determines the exchange rate of its currency, but can alter the exchange rate at its discretion. Conventional wisdom among economists holds that the growth of capital mobility in global financial markets has increasingly forced states to abandon pegged exchange rates. Many economists predict that as capital mobility grows states will gravitate either to rigidly fixed exchange rate regimes (such as monetary unions or currency boards) or to floating exchange rate regimes. The conventional wisdom, however, has not been subjected to statistical analysis. More importantly, it does not explain why some emerging-market countries have held onto exchange-rate pegs longer than others have. I argue that while the number of middle-income countries that peg their exchange rate has indeed declined over time, the reason some states held onto pegged exchange rates has more to do with their domestic political economy than with capital mobility. Specifically, I argue that the more that bank lending finances the commercial firms in a country, the more likely that state is to hold on to a pegged exchange rate. Bank credit is one form of financial intermediation. In a country where bank lending is strong, private firms tend to accumulate more external debt. External debt gives private firms an interest in maintaining a pegged exchange rate. The more banks lend to commercial firms, the stronger is the domestic political coalition between banks and commercial firms in favor of pegging. For evidence of this claim, I present a logit analysis of 26 emerging market countries for each year during the period from 1987 to 1996. The logit models assess the likelihood of whether or not a country uses an exchange-rate peg in a given year. Controlling for factors such as trade exposure, GDP, inflation rates, and the passage of time, two separate measures of financial intermediation through bank credit have significant results. Capital mobility does not. The cases of Thailand and Mexico illustrate how concentrated, protected banking sectors exercise influence in the policy-making process. The case of Colombia illustrates some of the limits of this theory.