Domestic Political Institutions and Exchange Rate Commitments in the Developing World

Abstract

Policymakers use a fixed exchange rate regime to signal their commitment to low inflation and to exchange rate stability. Increasing economic integration and the rise of democratic institutions make it more difficult for policymakers to maintain the credibility of this commitment. We use binary probit (with a variety of corrections for autocorrelated and heteroscedastic disturbances) to test hypotheses relating democratic institutions to exchange rate regime choice on a sample of 76 developing countries over the period 1973‐1994. The empirical analysis indicates that domestic political preferences—as measured by the structure of domestic political institutions and the fractionalization of the party system—influence exchange rate regime choice. We find that floating exchange rate regimes are more likely in democratic than in nondemocratic polities and that democratic polities with majoritarian electoral systems are more likely to fix their exchange rates than those with systems of proportional representation. The growth of international capital markets is truly extraordinary. Cross-border capital flows dwarf those of international trade: recent estimates suggest that foreign exchange trading alone now exceeds one trillion dollars a day. The magnitude and volatile nature of international capital flows has led some political economists to suggest that increased economic integration and capital mobility has become so pervasive that it now acts as a “structural characteristic of the international system, similar to anarchy” (Keohane and Milner, 1996:257). These scholars point to globalization as a crucial factor leading to a convergence of economic policy in the industrialized world. While a wave of economic liberalization has swept OECD economies, governments in developing countries still use a variety of traditional economic tools to protect the relative autonomy of their domestic policies. Vital in this process is exchange rate policy for it is the exchange rate that serves as a buffer between international and domestic markets. Even after the collapse of the Bretton Woods system of pegged exchange rates, most developing countries continue to fix the value of their currency to that of their major trading partner. The logic is clear: by fixing the domestic currency’s value to that of a trading partner, exchange rate volatility is minimized. As a result, bilateral flows of capital and goods are not disrupted by exchange rate uncertainty and