Political constraints and currency crises in emerging markets and less developed economies

Abstract

Political institutions may directly affect the likelihood of currency crises by influencing market confidence. They may indirectly affect the likelihood of currency crises by influencing economic fundamentals. This study uses econometric mediation to estimate both direct and indirect causal pathways for veto player theory—a common framework for analyzing political institutional constraints—and finds this approach improves upon the standard econometric approach in the extant literature, which only estimates the direct causal pathway. This new mediated approach shows that political constraints also indirectly reduce the likelihood of crises through strengthening key economic fundamentals. Additionally, the analysis finds that when global conditions are stable, more constraints are shown to directly reduce the risk of crises. When global conditions are volatile, more constraints are shown to directly increase the risk of crises. Global volatility is more likely to cause crises in countries with relatively constrained political systems, and vice versa.