Academic journal article International Review of Management and Business Research

Financial Development and Optimal Exchange Rate Regime Choice in Developing Countries

Academic journal article International Review of Management and Business Research

Financial Development and Optimal Exchange Rate Regime Choice in Developing Countries

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Since the demise of the Bretton Woods system, exchange rate choices have been in the heart of policy debates amongst both academicians and politicians. Exchange rate regime choice approaches make some useful contributions, but the tradeoff between fixed and flexible regime is not yet resolved.

These approaches can be divided into two groups, traditional and modern approaches. Traditional exchange rate regime approaches focus on the optimal conditions for macroeconomic adjustments in an open economy. The optimal currency area (OCA thereafter) (Mundell, 1961; McKinnon, 1963; Kenen, 1969) relates the exchange rate regime choice to the country's size, openness, trade links and factors mobility. The stabilization approach associated to the Mundell-Fleming framework considers real-nominal variability tradeoff according to which fixed (flexible) exchange rates are preferred as shock absorber in a country facing mainly nominal (real) shocks. These approaches examine mainly good and labor markets equilibrium and ignore the financial market. Otherwise, empirical literature shows the limited ability of these approaches to predict real countries regimes choices especially in developing countries (Calvo and Mishkin, 2003).

Among modern approaches, the political view suggests a peg as "policy crutches" for governments lacking credibility (Barro and Gordon, 1983). Moreover, international financial integration renewed interest on the impossible trinity view of Mundell-Fleming. It stresses the role of capital mobility as a factor preventing monetary authorities from allying exchange rate regime stability and monetary policy independence. More recently, an influential paper of Calvo and Reinhart (2002) introduces the "fear of floating" theory. Actually, emerging and developing countries are afraid to allow their exchange rate to fluctuate because of the balance sheet implications in financially dollarized economies, even announcing flexible regimes ((Eichengreen and Hausmann, 1999).

Arguments advanced by these last two theoretical approaches suggest opposite implications of financial sector openness on exchange rate regime choice. Impossible trinity states that financial integration enhances financial innovation and sophistication, which reduces the effectiveness of capital controls and leaves to monetary authorities the only choice of floating to ensure their independence. Although, the "fear of floating" theory suggests a fixed regime in a country financially open and largely indebted in foreign currency.

Furthermore, currency crises of the last decade of the twentieth century and their devastating consequences point to the financial sector weaknesses as potential causes of these crises. So, literature on currency crises prevention focuses, among others, on the exchange rate regime that shelters the economy from such crises (Frankel and Rose, 1998; Chang and Velasco, 2000).

Otherwise, financial development conditions the effect of monetary policy on growth. Financial system weakness prevents a flexible regime to play its countercyclical role to absorb an external chock (Céspedes, Chang and Velasco, 2004). This idea is later formalized by Aghion et al.(2009). They conclude that weak and repressed financial sector combined with a flexible exchange rate regime hinders productivity growth. These theoretical developments suggest that financial sector development affect exchange rate regime choice. So, in this paper, we attempt to empirically investigate the role of financial development in the choice of exchange rate regime.

But, measuring financial development is a difficult task. Financial development is a multifaceted concept that cannot be captured by standard indicators such as the ratio of broad money (M2) to GDP or credit on private sector to GDP1. Also, several studies highlight the role of institutional development (Schleifer and Vishny (1997), Levine (1997, 98), La Porta et al. …

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