Borrowing to Defend the Exchange Rate and the Timing and Magnitude of Speculative Attacks

The paper extends the recent literature on the collapse of managed exchange-rate regimes by allowing explicitly for the government budget constraint and the interest cost of servicing the public debt. The policy experiment analysed in this paper is the decision by a government to replenish its stock of foreign exchange reserves through a once-off open market sale of bonds. Without a fundamental fiscal correction (i.e. a decision to reduce the primary (non-interest) deficit by an amount equal to the increase in the interest cost of servicing the debt) the consequences of this policy are as follows: in a deterministic model, the timing of the speculative attack is brought forward (delayed) if the borrowing takes place long before (close to) the date at which without borrowing the collapse would have occurred. The magnitude of the attack (the final loss of reserves) always increases because of borrowing. In a stochastic model, borrowing reduces the probability of an early collapse and increases the likelihood of a later collapse. Under mild conditions, the expected length of the time interval until the collapse occurs is increased by borrowing.