The impact of politics on exchange rate fluctuations: The untold story

Exchange rate fluctuations send the wrong message to economic agents, affect the credibility of the government and result in loss of welfare for the whole society. Therefore, the optimal economic and political scenario revolves around stable equilibrium exchange rates. This paper is concerned with long term trends and builds up on balance of payment explanations of exchange rates fluctuations but adds a political perspective. It contends that effective governments will provide trust in their capacity of managing and implementing the necessary policies to avoid misalignments, especially recurrent devaluations. Using cross‐pooled time series analysis for 90 countries during 1960–1985, I find that while the economic explanation is straight forward, politics provides a nonlinear interpretation. Higher level of reserves provides governments with flexibility to intervene in the foreign exchange market; high levels of indebtedness are counterproductive to maintain a strong domestic currency but, the current account balance is not a significant predictor. Somewhat counter intuitively, I find that strong governments are at the mercy of economic forces; while weak governments, that could effectively use political tools to avoid devaluations, are prevented from doing so by their very weakness. Thus, political interventions are most effective when applied by weak governments who can seldom muster the capacity to do so, and least effective when applied by capable governments who act in hopes of altering their economic environment. The policy implications are important because political interventions could be very successful when accompanied by marginal increases in the political capacity of weak governments.