Political Regimes and Currency Crises

Abstract

This paper examines the relationship between political regime type and currency crises. Some theories suggest that democratic regimes, owing to their greater political transparency and larger number of veto players, should have a lower risk of currency crisis than dictatorships. Alternative arguments emphasize the advantages of political insulation and rulers with long time horizons, and imply that crises should be most likely in democracies and least common in monarchic dictatorships. We evaluate these competing arguments across four types of political regimes using a time‐series cross‐sectional dataset that covers 178 countries between 1973 and 2009. Our findings suggest that the risk of currency crisis is substantially lower in monarchies than in democracies and other types of dictatorship. Further analyses indicate that the adoption of prudent financial policies largely account for this robust negative association between monarchies and the probability of currency crises. This suggests that political regimes strongly influence financial stability, and perverse political incentives help explain why currency crises are so common.

Transparency and currency crises

“…I obtain the cross-national measure of currency crises from Steinberg et al (2015), which uses Frankel and Rose's (1996) definition of currency crisis based upon changes in a country's actual foreign exchange rate. I obtain the cross-national measure of currency crises from Steinberg et al (2015), which uses Frankel and Rose's (1996) definition of currency crisis based upon changes in a country's actual foreign exchange rate.…”

“…A country is coded as having experienced a currency crisis when its nominal exchange rate depreciates by more than 25% within 1 year and when this depreciation exceeds the prior year's depreciation by at least 10%. These variables are obtained from the replication materials associated with Steinberg et al (2015). To ensure the robustness of the result, I also attempt to use two alternative measures of a currency crisis: a depreciation that is >25%, as defined by Reinhart and Rogoff (2009), and a depreciation in excess of 30% that is also an increase in the rate of depreciation by at least 10%, as defined by Laeven and Valencia (2008).…”

“…To control for potential confounding variables, my primary specifications include several macroeconomic and financial fundamentals that have been suggested as determinants of currency crises: real GDP per capita (logged, from Graham & Tucker, 2017;World Bank, 2015 andFeenstra, Inklaar, &Timmer, 2015), GDP growth (annual % change in GDP per capita, from Graham & Tucker, 2017), trade openness (from Graham & Tucker, 2017), current account balance (from World Bank, 2015), the ratio of foreign reserves to GDP (from Steinberg et al, 2015), the level of exchange rate overvaluation (from Steinberg et al, 2015), the annual rate of inflation (logged, from Steinberg et al, 2015), and the total number of currency crises in other countries in the previous year (from Steinberg et al, 2015). To control for potential confounding variables, my primary specifications include several macroeconomic and financial fundamentals that have been suggested as determinants of currency crises: real GDP per capita (logged, from Graham & Tucker, 2017;World Bank, 2015 andFeenstra, Inklaar, &Timmer, 2015), GDP growth (annual % change in GDP per capita, from Graham & Tucker, 2017), trade openness (from Graham & Tucker, 2017), current account balance (from World Bank, 2015), the ratio of foreign reserves to GDP (from Steinberg et al, 2015), the level of exchange rate overvaluation (from Steinberg et al, 2015), the annual rate of inflation (logged, from Steinberg et al, 2015), and the total number of currency crises in other countries in the previous year (from Steinberg et al, 2015).…”

“…Many studies focus on economic variables, including macroeconomic and financial fundamentals, as determinants of currency crises (e.g., Frankel & Rose, 1996;Kaminsky, Lizondo, & Reinhart, 1998;Kaminsky & Reinhart, 1999). A smaller number of studies document the effect of political variables, such as political regime type (Steinberg, Koesel, & Thompson, 2015), democratization (Hays, Freeman, & Nesseth, 2003;Son, 2016), types of political institutions (Leblang & Satyanath, 2006;MacIntyre, 2001;Walter, 2009), and amount of political instability (Eichengreen, Rose, & Wyplosz, 1995;Leblang & Satyanath, 2006.…”

“…Moreover, transparency is commonly proposed as one of the key mechanisms behind the argument that democracies are less prone to currency crises than nondemocracies (Block, 2003;Leblang & Satyanath, 2006;Steinberg et al, 2015). Democracies make decision-making processes more open and observable to market participants (Broz, 2002;Schultz, 2001), allow a greater degree of media freedom (Egorov, Guriev, & Sonin, 2009), and provide more accurate and timely information about economic conditions to market participants (Bueno de Mesquita, Smith, Siverson, & Morrow, 2003;Hollyer, Rosendorff, & Vreeland, 2011).…”