Capital Market Development, Corporate Governance and the Credibility of Exchange Rate Pegs

We build a model of a fixed exchange rate regime with escape clauses and output persistence. In the spirit of the literature following the Asian crisis in 1997, persistence in our model arises from the inability of the domestic financial institutions to intermediate international credit. Our main message is that since persistence generates long run credibility effects that are sensitive to the prevailing policy preferences, the choice of an optimal exchange rate regime and the preference for a policy target should reflect the degree of development of the domestic financial institutions. If the domestic financial market suffers from credit constraints that generate persistence, the likelihood of self-fulfilling currency crisis may be reduced if the government assigns a greater weight on the output stabilisation objective. However, if financial market liberalisation successfully eliminates the credit constraints, liberalisation should be associated with a switch in policy preferences more in favour of exchange rate stability.