Say You Fix, Enjoy and Relax: The Deleterious Effect of Peg Announcements on Fiscal Discipline

Abstract

This paper explores the impact of actual exchange rate regimes on fiscal discipline, which we purportedly link to the effect of announcing the peg and to the availability of external funds. To stress this point, the focus of the analysis is emerging markets spanning from the beginning of the nineties, given the importance of financial integration in the last fifteen years and the centrality of external financing for these countries. We empirically show that announcing the pegs has deleterious effects on fiscal discipline, while 'de facto' pegs which have not been announced deliver superior fiscal outcomes. The evidence suggests that this is due to the initial positive credibility shock of the announcement, which allows for easier and less costly access to the financing of fiscal deficits in emerging countries.

Exchange Rate Regimes and Fiscal Discipline: The Role of Capital Controls

“…First, we consider the de facto Levy Yeyati and Sturzenegger (2005) classification for those ERRs operating under unified rates. Therefore, distinguishing between what countries claim to do (i.e., announcement) and what they actually do clearly matters when analyzing the influence of ERRs on diverse macroeconomic variables, including the primary fiscal balance (Alberola and Molina 2004;Alberola, Molina, and Navia 2005). Dual regimes are still associated with higher fiscal deficits than either regime operating under unified rates.…”

“…Following the empirical literature, we examine the effects of alternative exchange rate regimes on the fiscal deficit treating all regressors as exogenous Velasco 1998, 2000;Fatás and Rose 2001;Alberola and Molina 2004;Alberola, Molina, and Navia 2005). Column 1 of Table 1 shows the unconditional effect in a dynamic model.…”

“…The modeling structure borrowed from Tornell and Velasco (1998) does not come free of limitations. Our model does not articulate the potential strategic use of ERR announcements; see the study of Alberola, Molina, and Navia (2005) for empirical evidence on this regard. It does not analyze either the role of ideology (Chang 2007) or the endogenous end of stabilization plans associated to IMF programs (Díaz Cassou, García Herrero, and Molina 2006).…”

“…However, Velasco (1998, 2000) take issue with the previous view by considering political economy arguments. Velasco 1998, 2000;Fatás and Rose 2001;Alberola and Molina 2004;Alberola, Molina, and Navia 2005). A limitation of this literature is that it assumes perfect capital mobility, even though unrestricted capital flows seem to be the exception rather than the rule.…”

The Impact of Fixed Exchange Rates on Fiscal Discipline

“…Therefore, the transformation of the model in the first differences, as performed for the Arellano–Bond estimator, might, in some situations, lead to flawed estimates, as will be shown in Section . Two recent papers attempt to test several possible counteracting effects of pegged exchange rates on fiscal discipline explicitly (Alberola and Molina, ; Alberola et al ., ). While this is an interesting approach, the results are dubious due to several methodological problems.…”