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Exchange Rate Regime Credibility, the Agency Cost of Capital and Devaluation

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  • Roger Craine

    (University of California, Berkeley)

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    Abstract

    When a country abandons a fixed, or target zone exchange regime it usually claims that the regime was "fundamentally" sound but that it was undermined by pernicious speculation. The validity of the claim is impossible to assess using only observable data-there always exists a future path of current account surpluses that would make the regime sound, and speculators' (investors'?) motives are unobservable. This paper analyzes the crucial role of imperfect credibility in a currency crisis with a stochastic dynamic rational expectations regime switch model. The exchange regime is sound, e.g., a currency board-the only market failure is that the Central Bank cannot make a credible commitment to maintain the regime. The paper has two innovations: (1) It specifies the cost of imperfect credibility, and (2) It quantifies the cost of imperfect credibility. Imperfect credibility generates small (but costly) average interest rate differentials. Imperfect credibility cannot generate large interest differentials, but a surprisingly small "fundamental" currency overvaluation added to the basic specification generates large interest rate differentials. The paper's main result- that a lack of credibility cannot generate large interest rate differentials in a sound regime-is robust. The model in the paper is stylized, but the results are rich. The policy maker (Central Bank) and investors optimize. Investors fear devaluation and the Bank cannot make a credible commitment to allay their fears. Investors demand an agency currency premium. There is no pernicious speculation-the premium fairly prices the country's assets but it increases the country's cost of capital. The Bank abandons the regime when the expected present value of the agency cost of capital outweighs the expected present value of the benefit from remaining in the regime. The model generates multiple rational expectations equilibria and a variety of patterns linking the exchange rate to the interest rate differential. I parameterized the model using estimates of the exchange rate process for Hong Kong. The model generated agency currency premiums average ½%. The model generated interest rate differentials are consistent with the interest differentials in Hong Kong before the Asian financial crisis in July of 1997. After July 1997 a lack of credibility is not sufficient to explain the observed interest rate differentials of 4-6%.

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    File URL: http://128.118.178.162/eps/if/papers/9902/9902002.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series International Finance with number 9902002.

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    Length: 44 pages
    Date of creation: 18 Feb 1999
    Date of revision:
    Handle: RePEc:wpa:wuwpif:9902002

    Note: Type of Document - Acrobat.pdf; pages: 44; figures: included
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    Web page: http://128.118.178.162

    Related research

    Keywords: balance of payments crisis; credibility; multiple equilibria;

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    References

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Allan Drazen & Paul R. Masson, 1993. "Credibility of Policies versus Credibility of Policymakers," NBER Working Papers 4448, National Bureau of Economic Research, Inc.
    3. Bensaid, B.B. & Jeanne, O., 1995. "The Instability of Fixed Exchange Rate Systems when Raising the Nominal Interest Rate is Costly," Papers 9536, Tilburg - Center for Economic Research.
    4. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
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    6. Garber, Peter M. & Svensson, Lars E.O., 1995. "The operation and collapse of fixed exchange rate regimes," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 36, pages 1865-1911 Elsevier.
    7. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
    8. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
    9. Rust, John, 1996. "Numerical dynamic programming in economics," Handbook of Computational Economics, in: H. M. Amman & D. A. Kendrick & J. Rust (ed.), Handbook of Computational Economics, edition 1, volume 1, chapter 14, pages 619-729 Elsevier.
    10. Andrew K. Rose & Lars E.O. Svensson, 1993. "European Exchange Rate Credibility Before the Fall," NBER Working Papers 4495, National Bureau of Economic Research, Inc.
    11. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
    12. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
    13. Jeanne, Olivier, 1997. "Are currency crises self-fulfilling?: A test," Journal of International Economics, Elsevier, vol. 43(3-4), pages 263-286, November.
    14. Olivier Jeanne and Paul Masson., 1997. "Was the French Franc Crisis a Sunspot Equilibrium?," Center for International and Development Economics Research (CIDER) Working Papers C97-095, University of California at Berkeley.
    15. Kenneth Kletzer & Mark M. Spiegel, 1996. "Speculative capital inflows and exchange rate targeting in the Pacific Basin: theory and evidence," Proceedings, Federal Reserve Bank of San Francisco, pages 409-435.
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