Crises and Credibility: essays on currency pegs

Abstract

The various crises in international financial markets have highlighted the fact that liberalised capital flows are not necessarily better when a country's financial-market integration is not accompanied by the acquisition of financial reputation. In this thesis, financial reputation is taken to refer to the credibility of the interaction between the degree of financial-market integration, exchange rate arrangements and the accompanying policy responses, which is the subject of close scrutiny by international lenders and ratings agencies. This scrutiny is particularly intense when authorities pursue exchange rate stability by adopting fixed but adjustable currency pegs as these were almost always subject to crises in the recent past. Despite these problems, limiting exchange rate variability is often seen by policymakers as a key element in acquiring reputation, especially when market access is contingent on currency stability. The notion that many policymakers prefer exchange rate stability together with the observation that acquiring reputation necessarily implies a positive interaction between financial integration, exchange rate regime and economic policy motivate the focus of this thesis. Specifically, it investigates the impact of this interaction on certain policy instruments, namely those associated with fiscal and intervention policy, and, where possible, seeks to infer whether it signals financial reputation. The thesis' hypothesis is that exchange rate stability necessarily entails a lack of financialmarket integration or the absence/restricted use of discretionary policy instruments. In other words, authorities must be willing to voluntarily relinquish or limit their use of the policy instruments that they can control, and can therefore manipulate, when fixing the exchange rate in order to pass the market test of certifying their financial reputation. The thesis' research confirms this hypothesis and also lends weight to the view that acquiring financial reputation is a pre-requisite for integrating global capital markets. When this integration condition is not fully satisfied, the research suggests that a country needs to demonstrate its willingness to put up the necessary “collateral”, through taxation if necessary, in order to access global financial markets at the chosen currency peg. When it is satisfied, the prevailing currency peg will reflect the intertemporal credibility of monetary and fiscal policies and consequently will be able to successfully withstand the close scrutiny of international markets.