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What does really discipline fiscal policy in emerging markets? The role and dynamics of exchange rate regimes

Author

Listed:
  • Enrique Alberola

    () (Banco de España)

  • Luis Molina

    () (Banco de España)

Abstract

Fixing the exchange rate stabilises inflation and reduces monetary seignoriage, a key source of financing under the fiscal dominance hypothesis. However, the link between fixed exchange rate regimes and fiscal discipline in emerging markets has been found to be weak. This paper thoroughly reviews the issue through three venues. First, an alternative measure to gauge fiscal discipline –the so called shadow balance, inclusive of seignoriage revenues– is proposed, since the traditional one, the primary balance, does not convey monetary financing; notwithstanding this modification, no robust relation is found either. Second, we sustain and then prove the hypothesis that fixing the exchange rate may have offsetting effects on fiscal discipline through the relaxation of the fiscal constraint of the government. In particular fixing the exchange rate is expected to reduce the cost and burden of debt and to enhance the ability to obtain revenues through a higher level of activity. The empirical test of this hypothesis follows a two stage approach. First, we test the impact of the fiscal constraints on discipline: as advocated, a higher fiscal burden induces higher discipline; higher activity does not clearly relax discipline, although expenditures grow and the burden of debt is shown to diminish. The second stage tests the impact of fixed regime on the considered determinants. Again, the relation between fixed regimes and the reduction of the burden is robust, but not so the impact of fixed regimes on the cycle. Third, we explore the dynamics related to the pegging of the exchange rate, uncovering that at its inception exchange rates trigger an expansion and reduce the debt burden. This final outcome does not only strengthen our hypothesis but illustrates how the peg sows the seeds of its own destruction, also at the fiscal level.

Suggested Citation

  • Enrique Alberola & Luis Molina, 2004. "What does really discipline fiscal policy in emerging markets? The role and dynamics of exchange rate regimes," Working Papers 0402, Banco de España;Working Papers Homepage.
  • Handle: RePEc:bde:wpaper:0402
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    References listed on IDEAS

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    Cited by:

    1. Rupa Duttagupta & Guillermo Tolosa, 2007. "Fiscal Discipline and Exchange Rate Arrangements: Evidence from the Caribbean," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 43(6), pages 87-112, November.
    2. Enrique Alberola & Manuel Montero, 2006. "Debt Sustainability and Procyclical Fiscal Policies in Latin America," ECONOMIA JOURNAL, THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION - LACEA, vol. 0(Fall 2006), pages 157-193, August.
    3. Francisco Ledesma-Rodríguez & Manuel Navarro-Ibáñezr & Jorge Pérez-Rodríguez & Simón Sosvilla-Rivero, "undated". "Implicit regimes for the Spanish Peseta/Deutschmark exchange rate," Working Papers 2005-21, FEDEA.
    4. Rupa Duttagupta & Guillermo Tolosa, 2006. "Fiscal Discipline and Exchange Rate Regimes; Evidence From the Caribbean," IMF Working Papers 06/119, International Monetary Fund.
    5. Ledesma Rodríguez, Francisco J. & Ibáñez, Manuel Navarro & Pérez Rodríguez, Jorge V. & Rivero, Simón Sosvilla, 2005. "Regímenes cambiarios de iure y de facto. El caso de la peseta/dólar, 1965–1998," Revista de Historia Económica, Cambridge University Press, vol. 23(03), pages 541-561, December.
    6. Alberola, Enrique & Molina, Luis & Navia, Daniel, 2007. "Say you fix, enjoy and relax. The deleterious effect of peg announcements on fiscal discipline in emerging markets," Emerging Markets Review, Elsevier, vol. 8(4), pages 328-338, December.
    7. Rupa Duttagupta & Guillermo Tolosa, 2007. "Fiscal Discipline and Exchange Rate Arrangements: Evidence from the Caribbean," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 43(6), pages 87-112, November.
    8. repec:got:cegedp:84 is not listed on IDEAS
    9. Makram El‐Shagi, 2011. "The Impact of Fixed Exchange Rates on Fiscal Discipline," Scottish Journal of Political Economy, Scottish Economic Society, vol. 58(5), pages 685-710, November.
    10. Adela Luque, 2005. "Skill mix and technology in Spain: evidence from firm level data," Working Papers 0513, Banco de España;Working Papers Homepage.
    11. Francisco Ledesma-Rodríguez & Manuel Navarro-Ibáñez & Jorge Pérez-Rodríguez & Simón Sosvilla-Rivero, "undated". "Regímenes cambiarios de facto y de iure. Una aplicación al tipo de cambio yen/dólar," Working Papers 2004-10, FEDEA.
    12. Guillermo Vuletin, 2013. "Exchange Rate Regimes And Fiscal Discipline: The Role Of Capital Controls," Economic Inquiry, Western Economic Association International, vol. 51(4), pages 2096-2109, October.

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    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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