Exchange rates and currency crises
Contractionary currency crashes in developing countries
How to minimise vulnerability to currency contractions in developing countries
Authors:
J. Frankel
Publisher:
Center for International Development, Harvard University, 2005
This paper was presented as the Mundell-Fleming Lecture at the IMF Annual Research Conference. This paper begins with the question of why currency contractions are so politically costly? According to the author, updating a previous statistic, a political leader in a developing country is twice as likely to lose office in the 6 months following a currency crash as otherwise. Is this, he asks, as alleged: because of excessive reliance on raising the interest rate as a policy response? Instead, he finds that it is more likely because of contractionary effects of devaluation.
The author finds that there are at least two ways of seeking to minimize vulnerability to sudden stops, devaluations, and associated economic contractions: keeping balance sheets strong by avoiding a shift to short-term dollar debt as a means of procrastination, and keeping the economy open to trade. The paper began by noting the frequency with which political leaders and ministers lose office after a devaluation, but concludes that seeking to hold on to political viability is presumably the precise reason why governments often procrastinate, why they feel they have to postpone adjustment to balance of payments deficits, and instead run down reserves, shorten the maturity of the debt, and borrow in dollars. So the openness strategy may be the most robust option, politically as well as economically. [adapted from author]
