Political booms and currency crises

Abstract

This paper shows evidence that political booms, defined as the rise in governments’ popularity, are associated with a higher likelihood of currency crises. The reasoning behind this finding is that prudent economic policies to address underlying weaknesses in the economy may be political costly for incumbent governments in the short-term. Hence, popularity-concerned governments may not have enough incentives to take such corrective actions in a timely manner. This approach, in turn, can deteriorate economic fundamentals and increase related risks in the economy which can eventually lead to crises. This paper sheds light on this phenomenon in the case of currency crises, suggesting that currency crises can be viewed as “political booms gone bust” events. Moreover, it finds that higher international reserves, higher exports, and a higher degree of financial openness alleviate the effect of political booms on currency crises.