Michael G. Hall - Exchange Rate Crises in Developing Countries: The Political Role of the Banking Sector

EXCHANGE RATE CRISES IN DEVELOPING COUNTRIES

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The Political Role of the Banking Sector

Michael G. Hall
University of Northern Iowa, USA

First published 2005 by Ashgate Publishing

Reissued 2018 by Routledge
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Michael G. Hall 2005

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ISBN 13: 978-0-815-38896-8 (hbk)
ISBN 13: 978-1-351-15844-2 (ebk)

The 1990s saw a number of exchange-rate crises in developing countries, ranging from Mexico to East Asia, to Brazil, to Russia. The puzzling aspect of so many of these crises was that they struck developing states that were growing rapidly or had significantly reformed their economies. The crises renewed a long-running debate among economists concerning who or what was responsible for the crises. Some economists argued that the governments of these countries were to blame for pursuing inflationary economic policies or failing to provide the proper regulation of domestic financial institutions. Other economists argued that free financial markets are inherently unstable and the herd mentality of investors produced panics over the exchange rates of particular countries. But the rash of exchange rate crises in the 1990s also provided the backdrop for a new idea, that "pegging" the exchange rate in an environment of high "capital mobility" increased the risks of an exchange rate crisis. With a pegged exchange rate, a government promises to exchange its currency for other currencies at a specified rate, but it may not have enough foreign currency on hand to satisfy everyone who wants to buy foreign currency. In most cases this may not be a problem, just as a bank does not have the cash on hand equal to all of the deposits of its customers, since the chance that all bank customers will withdraw their money from their accounts simultaneously is so unlikely. Some economists, however, have argued that in todays world of international finance, where investors can transfer and exchange huge sums of money across national borders with electronic speed, a government promise to exchange currency, if not given solid backing, risks a situation in which the government cannot sell foreign currency to all of those that demand it. These situations are crises and the governments credibility in setting exchange rates collapses. Many of the states listed above had some form of pegged exchange rates before they experienced a crisis. Economists thus focused more attention on how exchange-rate policy affects the likelihood of exchange-rate crises.

But if pegging contributes to crises, why did these governments peg their exchange rates? Some of the older answers to this question, which focused on purely economic variables such as the size of the states economy or its degree of exposure to international trade, no longer seem enough to explain why governments choose to peg. Newer scholarship on political economy, which explains economic policy as the result of political forces, has drawn attention to a whole new set of explanations. Different scholars have argued that states peg in order to please manufacturers, or in order to maintain public confidence before an election, or because dictatorships have few alternatives in combating inflation. If true, these explanations may give us clues as to what has to change to alter exchange rate policies and to prevent further exchange-rate crises. This book examines the validity of all of these explanations, both economic and political, in the light of evidence from statistical tests and case studies.