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Exchange Rate Policy and Debt Crises in Emerging Economies

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  • Peter Montiel
  • Samir Jahjah

Abstract

We explore a model intended to capture the interaction between exchange rate policy, fiscal policy, and outright default on foreign-currency denominated debt. We examine how the exchange rate affects the supply of short-term debt facing the government. We show that under a credible hard peg (currency board), default is a more likely outcome, even without an exceptionally large short-term debt, precisely because a devaluation is not an option. In a more conventional fixed peg, it can be optimal for the government to choose a level of the exchange rate that would be likely to result in partial or complete debt default. Depending on the exchange rate regime, multiple equilibria exist, in one of which the interest rate is high, the exchange rate is overvalued, output is low, and default is high. Under a hard peg, there is a unique equilibrium.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/60.

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Length: 22
Date of creation: 01 Mar 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/60

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Keywords: Devaluation; External debt; Emerging markets; exchange rate; short-term debt; exchange rate policy; real exchange rate; debt service; debt crisis; exchange rate misalignment; long-term debt; real exchange rate misalignment; debt default; currency board; debt service obligations; sovereign debt; exchange rate overvaluation; currency crises; government debt; exchange rate changes; exchange rate depreciation; debt crises; nominal exchange rate; real exchange rate overvaluation; debt-service obligations; currency crisis; exchange rate peg; debt sustainability; exchange rate regime; exchange rate adjustments; international lending; exchange rate adjustment; public debt; currency risk; external borrowing; debt service payments; public sector debt; amount of debt; balance of payment; exchange rate change; central banks; reserve bank; balance of payment crises; exchange rate mechanism; domestic agent; effective exchange rate; central bank; international debt; debt outstanding; exchange rate flexibility; fixed exchange rate; external shocks; sovereign default; debt problems; overvalued exchange rate; sovereign borrowers; exchange rate policies; debt defaults; real effective exchange rate; exchange rate commitments; currency debt;

References

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  1. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-78, February.
  2. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
  3. Wiesner, Eduardo, 1985. "Latin American Debt: Lessons and Pending Issues," American Economic Review, American Economic Association, vol. 75(2), pages 191-95, May.
  4. James Conklin, 1998. "The Theory of Sovereign Debt and Spain under Philip II," Journal of Political Economy, University of Chicago Press, vol. 106(3), pages 483-513, June.
  5. Diamond, Douglas W. & Rajan, Raghuram G., 2001. "Banks, short-term debt and financial crises: theory, policy implications and applications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 37-71, June.
  6. Carmen M. Reinhart, 2002. "Default, Currency Crises, and Sovereign Credit Ratings," World Bank Economic Review, World Bank Group, vol. 16(2), pages 151-170, August.
  7. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June.
  8. Christopher A. Sims, 2001. "Fiscal consequences for Mexico of adopting the dollar," Proceedings, Federal Reserve Bank of Cleveland, pages 597-625.
  9. Harold L. Cole & Patrick J. Kehoe, 1996. "Reputation spillover across relationships: reviving reputation models of debt," Staff Report 209, Federal Reserve Bank of Minneapolis.
  10. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fixing for Your Life," NBER Working Papers 8006, National Bureau of Economic Research, Inc.
  11. Eichengreen, Barry, 1990. "Historical Research on International Lending and Debt," Department of Economics, Working Paper Series qt39n6n9ns, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  12. Catherine A. Pattillo & Andrew Berg & Gian-Maria Milesi-Ferretti & Eduardo Borensztein, 2000. "Anticipating Balance of Payments Crises," IMF Occasional Papers 186, International Monetary Fund.
  13. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  14. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
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Citations

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Cited by:
  1. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc.
    • Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
  2. Bauer, Christian & Herz, Bernhard & Karb, Volker, 2007. "Are twin currency and debt crises special?," Journal of Financial Stability, Elsevier, vol. 3(1), pages 59-84, April.
  3. Eijffinger, Sylvester C W & Karatas, Bilge, 2013. "Three Sisters: The Interlinkage between Sovereign Debt, Currency and Banking Crises," CEPR Discussion Papers 9369, C.E.P.R. Discussion Papers.
  4. Nawaz A. Hakro & Wadho Waqar Ahmed, 2006. "IMF Stabilization Programs, Policy Conduct and Macroeconomic Outcomes: A Case Study of Pakistan," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 11(1), pages 35-62, Jan-Jun.
  5. Axel Dreher & Bernhard Herz & Volker Karb, 2004. "Is There a Causal Link between Currency and Debt Crises?," International Finance 0404005, EconWPA, revised 16 Feb 2005.
  6. Hefeker, Carsten, 2007. "Default, Electoral Uncertainty and the Choice of Exchange Regime," Proceedings of the German Development Economics Conference, Göttingen 2007 13, Verein für Socialpolitik, Research Committee Development Economics.

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