Why do Governments Delay Devaluation?

Why do Governments Delay Devaluation?

Why do Governments Delay Devaluation? The political economy of exchange rate inertia Graham Bird & Thomas D. Willett

Introduction A question that frequently arose in the context of economic crises during the 1990s was why, in the face of worsening balance of payments problems, devaluation was frequently delayed until a crisis hit. Often such delays resulted in much greater costs when devaluations were eventually undertaken. A failure to act can, in principle, be explained by a lack of perfect foresight. But the frequency with which this pattern has occurred suggests that more systematic factors are also at work. In this article we argue that it is difficult to explain the delay in devaluing on the basis of economic efficiency considerations alone. However, when the political implications of such economic considerations are taken into account the pattern becomes much more understandable. Recent analysis has begun to be devoted to the political economy of the choice and operation of exchange rate regimes (see for example, Leblang 1999, 2003; Willett 2003). We draw on this literature to offer a practical guide to the key factors likely to bias the operation of adjustable peg or managed exchange rate regimes toward excessive delay in making adjustments. This yields a checklist of political and institutional reforms that may be

Graham Bird is Professor of Economics at the University of Surrey and Director of the Surrey Centre for International Economic Studies. Thomas D. Willett is the Dean of the School of Politics and Economics and the Horton Professor of Economics in the Department of Economics, Claremont Graduate University and Claremont McKenna College.

WORLD ECONOMICS • Vol. 9 • No. 4 • October–December 2008

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Graham Bird & Thomas D. Willett

needed by some countries in order to help ensure that the exchange rate regime is not a source of instability. There are many subtleties, however, that the article either ignores or skirts over cursorily. For example, once a decision is taken to seek a lower value for the currency, a government has to make a supplementary decision about the nature of the exchange rate regime within which this is to be achieved. One option, within an adjustable peg regime, is to lower the peg. It is essentially in the context of this type of regime that the analysis in this article is framed. But it is also possible that governments may opt for alternative arrangements. They may decide to move over to a flexible exchange rate regime, knowing that the foreign exchange market will drive down the value of the currency. Or they may opt for an intermediate regime between pegging and free flexibility (for a discussion of the choice of exchange rate regime see Bird 2002, Frankel 1999, Williamson 2000 and Willett 2006). They may, for example, announce a gradual slide in the parity. Analysing these options raises important additional issues, but they are not fully addressed here. The article is organised in the following way. The first section briefly rehearses some of the principal economic issues associated with devaluation. There are certainly things here that help to explain why devaluation may be delayed. The second section explores the political dimension of devaluation and this provides further reasons for the delay. The third section draws on the earlier ones to offer a brief and, it must be acknowledged, subjective assessment of why certain observed decisions were reached. In the light of contemporary global circumstances, the fourth section examines briefly the issue of delayed revaluation and assesses whether decisions to revalue will be delayed even longer. The last section concludes with a checklist of reforms that may help avoid excessive delay in the future.

The economics of delayed devaluation Devaluation is a way of seeking to correct balance of payments deficits. But what does this imply? If domestic output is to be maintained, it means directing resources away from domestic and towards foreign consumption. There is therefore a domestic sacrifice and governments will try to avoid

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making it if they can. At this early stage, we can therefore see why devaluation is something governments do not want to rush into. The economics of devaluation is fairly well established and may be approached in the following way. First, when faced with a balance of payments deficit there is an effective choice involving the extent to which it is corrected via adjustment policies and the extent to which it is financed by borrowing or by running down reserves. Financing a deficit postpones the sacrifice of consumption. The choice of balance of payments strategy and the mix between adjustment and financing depends first on whether or not the deficit is temporary, second on the relative costs of adjustment and financing and third on the social discount rate: to what extent does the government discount the future sacrifices of consumption that financing entails? If the deficit is deemed temporary, if the costs of short-term adjustment are perceived as high and the cost of financing is low, and if the social discount rate is high, countries will seek to avoid any form of short-term adjustment, including devaluation (for a general discussion of the issues see Alesina & Drazen 1991, Drazen 1996 and Fernandez & Rodrik 1991). Part of the problem in selecting an optimal blend of adjustment and financing is that few of its theoretical determinants are easy to measure. For example, it will be tempting to believe that balance of payments deficits will correct themselves given time – perhaps the terms of trade will move in a country’s favour. For as long as the financing option is available, this view may be used to justify adopting it, and postponing adjustment. Of course the financing option may not be available and its availability may be expected to diminish over time. Countries with low levels of international reserves and poor access to international capital markets may be forced to put more emphasis on short-term adjustment than they would like and this may mean earlier devaluation. Moreover, the external financing route will become more difficult to follow over time as reserves fall and as creditors become more concerned about lending to countries that are doing little to eliminate their balance of payments deficits. When a stage is reached where adjustment is pursued, the question becomes that of which adjustment policy is best. Devaluation is just one of a number of policies that may be considered. The actual selection will depend on a government’s evaluation of the merits and demerits of the alternative policies. From the point of view of policy selection, it is


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important to assess devaluation relative to the other policy options. For devaluation to be the preferred policy, it has to be seen as being both effective in correcting the balance of payments deficit and efficient in terms of doing minimum harm to other policy objectives such as economic growth, low unemployment and low inflation. In reality the optimal strategy will usually involve a combination of policies. Thus, for example, if a country is already at full employment, and if devaluation is expected to be expansionary, then it should be combined with monetary and/or fiscal tightening to avoid overheating the economy. In these circumstances, even though macro tightening is required, it needs to be less than if this were to be the only policy. Devaluation then allows the economy to avoid a substantial increase in unemployment. Thus our discussion of whether to use devaluation is really about whether it should be included as part of the policy strategy. For it to be effective, devaluation has to improve competitiveness and offset the disequilibria that generated the balance of payments deficit. Devaluation will be relatively ineffective if it leads to higher inflation, or if it causes foreign producers to change their pricing policies to neutralise its effects, or if it induces retaliatory actions in the form of competitive devaluations elsewhere. Countries will be less likely to devalue where these eventualities are seen as probable. This implies, for example, that economies that are relatively open may seek to avoid devaluation because they will be concerned about its inflationary consequences. However, it is not sufficient for devaluation to change the relative prices of imports and exports. There needs to be an adequately large response by consumers (and in some cases producers) to the change in relative prices. This brings us to the familiar Marshall Lerner condition, which spells out the values that key foreign trade price elasticities have to have to make devaluation effective; in standard form for advanced economies that the sum of import and export demand elasticities exceeds 1. If governments believe that the actual elasticities fail to comply with the Marshall Lerner condition they will tend to avoid devaluation. For small dependent economies the Marshall Lerner condition is less restrictive. For these countries, which denominate export prices in foreign currency, the condition is that the sum of the import demand and export supply elasticities exceeds zero. Devaluation will involve no domestic currency adverse terms of trade effect. While, in the past, developing countries have often resisted devalu-

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ation on the basis of failing to meet the Marshall Lerner condition, empirical evidence is largely at odds with this (International Monetary Fund 2006) and suggests that other reasons may lie behind their reluctance. Discussion of the Marshall Lerner condition does point to another significant consideration. Trade elasticities tend to be higher in the long term than in the short term. Thus, even a country that fails the relevant Marshall Lerner test in the short term, may pass it in the long term. In the case of the standard Marshall Lerner condition, the implication is that the balance of payments will get worse before it gets better: there will be a J curve. The fact that the benefits from devaluation may take time to filter through, whereas the costs may be almost immediate, probably goes a long way to explaining why many governments are reluctant to devalue. The adverse impact on prices tends to occur quickly. The full quantity responses may take as long as two years or over to materialise. Even for small dependent economies where the J curve is not relevant because the adverse terms of trade effect is absent, the beneficial effects of devaluation on the current account of the balance of payments will take time to emerge. For many years economists have also recognised that devaluation may have contractionary effects in the short term, as monetary expenditure on imports rises (assuming that the price elasticity of demand for them is low), as the real supply of money falls and interest rates rise and as indebted nations find that the domestic currency cost of servicing debt rises. Until recently most empirical studies found little evidence that these contractionary effects were important (Kamin 1988). This changed, however, with the currency depreciations in emerging market economies during the 1990s. Perhaps most dramatic were the deep recessions accompanying the Asian crisis of 1997–98. Where the domestic currency value of liabilities denominated in unhedged foreign currency is high relative to that of assets, depreciation can substantially reduce the net worth of businesses and financial institutions, sometimes resulting in insolvency and bankruptcy. The resulting negative impact on economic activity can be quite strong (Bird & Rajan 2004). Of course there will also be operational difficulties in determining the size of any required devaluation. Discussion of currency overvaluation implies that there is a secure way of calculating the equilibrium exchange rate. There is not (Isard 2007). Different approaches may yield different


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results. Moreover, there is the question of the mechanism by which a fall in the value of the currency may be brought about. For example, should there be an initial devaluation to a new pegged rate or should the currency just be unpegged and allowed to find its own level? There are arguments for and against both. What emerges from this analysis? Since most of the evidence suggests that except for quite small, highly open economies, devaluation does change relative prices (although not by as much as the size of the devaluation), that countries do comply with the Marshall Lerner condition (certainly in the long term), and that, apart from the balance sheet effects, devaluation is unlikely to be contractionary, and, even then, probably only for a relatively short time, it appears that the reasons for delay must lie elsewhere. Importantly, countries that place a high priority on keeping inflation low will tend to be more reluctant to devalue (see Bird 1998 and Hamann 2001 for a discussion of so-called exchange rate based stabilisation). Especially in circumstances that do not favour inflation targeting, a pegged exchange rate may help anchor inflationary expectations. This account of the devaluation decision may be couched in a slightly different way. Perhaps the main appeal of currency overvaluation lies in its counter-inflationary consequences. In this regard, contractionary demand management policies will be a more attractive alternative than devaluation since they too tend to be counter-inflationary. The fear of inflation may be joined by a fear of the effects of devaluation on exchange rate expectations and international capital movements. There is a ‘catch 22’ conundrum here. While devaluation seeks to eliminate currency overvaluation that invites speculative attack, devaluation itself may also invite a speculative attack if it leads international capital markets to anticipate that further depreciations are probable. This is especially likely if the initial devaluation is viewed as being too small. But the greater the devaluation, the higher its short-term economic costs. Recognition that only a large devaluation is likely to work can increase a government’s hesitancy to devalue. In spite of these concerns, a review of the issues implies that, in circumstances where a currency has become clearly overvalued, it is difficult to find a convincing general economic case to resist devaluation. The exceptions are for economies that are small and highly open, and those that have considerable wage and price flexibility and labour mobility. In the first

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case devaluation is unlikely to be very effective and in the second, the costs of restrictive macroeconomic policies as an alternative to devaluation will be low. Since postponing the decision merely prolongs the length of time the economy functions with a disequilibrium exchange rate, thereby encouraging the allocational inefficiencies that go along with it, there are strong economic reasons for prompt exchange rate adjustment (Edwards 1989). Many of the concerns surrounding devaluation can be dealt with in other ways. For example, the inflationary threat may be countered by appropriate fiscal and monetary policy, while the balance sheet effects may be minimised by appropriate portfolio management and financial supervision. The basic point remains that economics suggests that there is little to be gained and much to be lost by seeking to persevere with an overvalued currency. So why do governments delay devaluation? The answer lies in the politics of the decision.

The politics of delayed devaluation In the past, economists have shown a tendency to approach political factors as a residual. If some phenomenon cannot be adequately explained by economics, then it is assumed that political factors must be at work. However, these factors often remain ill-defined. Recent research in political economy has made it clear that only limited headway will be made unless both economic and political factors are fully considered. Thus both economists and political scientists are increasingly coming to recognise that if they are to better understand how governments decide on and implement economic policies it is necessary to adopt a political economy perspective that focuses on how economic and political considerations interact (see, for example, Drazen 2000, Persson & Tabellini 2000, Alesina & Roubini 1997 and Sturzenegger & Tommasi 1998). There are, of course, many different channels of interaction and political scientists exhibit differences in view about the key political factors in various situations, just as economists differ about their economic analysis. No one paper can succeed in adequately capturing all of the potentially relevant interactions. In this section we only attempt to lay out some of what we see as the most important factors. We do this under the headings of: distributional factors, timing, perceptions and uncertainty, and political strength.


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Distributional factors Distribution lies at the heart of politics. With any policy there will be gainers and losers. Governments will form a view about the identity of these groups and how important they are politically. In democratic systems governments will want the ‘median voter’ to gain at least at election time. They may not worry too much about losses being incurred either by groups that are unlikely to vote for them anyhow or by groups whose allegiance is already secure. Economic analysis allows us to identify the main beneficiaries from devaluation; simply put, those in export and import competing industries. But the reality is less simple since those involved in the traded goods sector may benefit from devaluation as producers or employees, but may lose as consumers if consumer prices rise as a consequence of the devaluation. Moreover, even producers of traded goods may be concerned that devaluation removes the discipline on workers to moderate wage demands, and they may then fear that wage inflation will erode the competitive advantage created by devaluation. In developing economies there may be an important urban/rural split. Urban workers may lose from devaluation if prices rise ahead of nominal wages. Rural workers may be able to protect themselves against rising food prices by engaging in subsistence agriculture and may benefit from devaluation in their supply role, since the domestic currency price of exported primary products will increase. In circumstances where urban workers are politically powerful the government may be reluctant to pursue a policy that can easily be seen as being associated with a fall in their real wages. Special interest groups disadvantaged by devaluation may also be in a strong position to resist it. For example, the banking and financial sector may have been poorly regulated and supervised, perhaps because the government relies on the banks to help finance fiscal deficits. This puts the financial sector in a strong bargaining position. The sector may fear that devaluation will drive up interest rates in line with prices and that this may increase the risks of default and financial meltdown. Furthermore, as noted above, the balance sheets of financial institutions and corporations may be vulnerable to the adverse effects of devaluation where they have large unhedged foreign currency exposure. The important point to make in all of this is that, from the perspective of the economy overall, the gains from devaluation may exceed the losses,

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but this does not guarantee that devaluation will occur if the losers from it are better organised, more articulate and have greater political power than the gainers. There are also well-catalogued distributional issues associated with devaluation within governments themselves. The government will not always speak with one voice. Trade ministries are likely to favour devaluation. Finance ministries may be more concerned about its inflationary consequences. And finance ministers will be aware that their career prospects may be adversely affected by being associated with devaluation (Cooper 1971). Timing It is not just in comedy that timing is important. It is also central to politics. Economic analysis establishes that the effects of devaluation filter through at different speeds. The adverse price effects tend to be immediate. To the extent that they exist, the recessionary effects will tend to occur quickly. The expansionary trade effects tend to take longer to emerge. Economists, particularly academic ones, may be inclined to take a long-term view and emphasize the positive side of devaluation. Politicians, however, are often myopic, and even if they themselves are long sighted they will be affected by interest groups and constituents who take a short-term view (Drazen 1996; Alesina & Drazen 1991). Thus governments will favour policies that have short-term benefits and, if they have to be incurred, only longterm costs. On this basis, devaluation is about the least desirable policy. Governments may therefore be reluctant to devalue unless there is no alternative option. It will be a policy of last resort. Politicians will live in hope that they can avoid it. They will hope that in the time period before devaluation becomes unavoidable, economic performance will get better; for example, in association with an improvement in the terms of trade. If policy change does become necessary, they will prefer to pursue policies where the costs are, to a greater extent, deferred. Basically, not devaluing has a significant political option value. Unfortunately, the main alternative adjustment mechanism, a tightening of macroeconomic policy, also has more of its costs (higher interest rates, slower growth and rising unemployment) in the short term, while the benefit of lower inflation typically takes longer to materialise. Thus the popular ‘default option’ is to continue to finance deficits for as long as international reserves or international


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borrowing is available (but see Rebelo & Vegh 2008). Indeed it is frequently the exhaustion of financing resources rather than calculations of the overall costs and benefits to the country that leads governments eventually to succumb to devaluation. The temptation for governments is to view balance of payments problems as temporary. This legitimises a strategy based on external financing and on seeking to defer altering the exchange rate. Finally, the myopia of politicians will be influenced by the timing of elections. An incumbent government will not want to devalue shortly before an election if the costs of devaluation emerge immediately or in the short term. Devaluation will make it more likely that the government loses power. What is worse from the perspective of the incumbent government in these circumstances is that the benefits from the devaluation may coincide with the installation of the new opposition government. Why would an incumbent government wish to inflict political damage on itself and confer political advantage on its political adversaries? Perceptions and uncertainty While economics emphasizes the importance of expectations, politics is a great deal about perceptions, and these may play a key role in helping to explain why governments delay devaluation. Economics tries to establish what will happen according to some underlying model of economic relationships. Politicians are driven by what they think people will think will happen and how they are expected to respond. The differences between perception and reality help explain why a policy that confers net gains may not be implemented. Governments typically believe that the gainers will not perceive or may understate their gain, and losers may over-estimate their losses. Moreover, governments may believe that those perceiving a loss from devaluation will respond more negatively than those who perceive a gain will respond positively. Devaluation is a very high profile and visible decision. In the context of an adjustable peg regime, it is more discrete than monetary policy and often fiscal policy as well. Governments may believe that the electorate in general will perceive devaluation as a sign of economic incompetence and failure. They may believe that people will see devaluation as debasing the currency. They may also believe that international capital markets will not only interpret devaluation as an indicator of past and contemporary

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economic mismanagement, but also as a signal that less discipline will be imposed on labour markets and on fiscal and monetary policy in the future. This may not be the reality at all, but again perceptions may be more important than reality in influencing decisions. These tendencies to delay will be strengthened the greater the uncertainty about underlying conditions and likely future developments. This is a point to which mainstream economics often has not given sufficient attention. There has been a tendency to assume that everyone knows the correct model, something that is especially ironic given the heated debates in macroeconomics between monetarists, Keynesians and new classical economists about what the correct model is. The basic philosophy of the Bretton Woods system for operating adjustable peg exchange rates was that with temporary payments imbalances financing was the appropriate strategy while in the case of ‘fundamental’, disequilibrium exchange rate pegs should be adjusted. In theory, this is a clear and sensible strategy. In practice, however, there is a great deal of uncertainty about what developments are temporary and what are longer term. And, even if the deficit is long term, under current conditions who is to say for sure that an economic boom abroad will not develop, which allows a country to export its way out of deficit without the need for devaluation. Thus, not only do the costs of adjustment tend to come first and the benefits later, but the costs of taking adjustment actions are certain (it is just their magnitudes that are uncertain), while the future costs from delaying adjustment not only occur later, but, if one is lucky, they may not occur at all. Such rationalising makes little sense within the context of rational expectations analysis favoured by some economists. Fortunately, an appreciation of the limitations of such analysis is spreading. Much research is being devoted to the implications of limited information and differences in models, as well as to the analysis of cognitive limitations and psychological biases emphasized by those working in behavioural and neuroeconomics and finance. Analysis of mental models holds out the prospect of bridging the divide between economists’ expectations and political scientists’ perceptions. A good deal of psychological research has documented tendencies toward optimistic biases in decision making and confirmation bias under


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which individuals give more weight to evidence that is consistent with their initial views or hopes and heavily discount evidence that conflicts with them. Given such tendencies, the evidence may need to be overwhelming for a government to acknowledge to itself that devaluation really is necessary. Political strength Even where government leaders are able to overcome such potential biases in themselves, they still may not be able to implement needed policies. This will depend on the political strength of the government. In a stable democracy where the government in power has a strong majority it may have considerable scope for doing what it thinks is right regardless of the short-term effects on its political popularity. In countries that are politically unstable there is usually much less scope for such leadership. Likewise coalition governments and those facing other configurations of political power that generate numerous veto players will often find their hands tied. Furthermore, an incumbent government may not be under any pressure to devalue from their parliamentary opposition. If devaluation is perceived by the general public as carrying economic costs and is politically unpopular, it is hardly likely that opposition parties will want to be seen as entreating the government to devalue.

A brief commentary on some devaluation episodes There is an increasing literature that tests many of the ideas that have been raised in this article (much of which is surveyed in Willett 2007 from the viewpoint of the instability of exchange rate regimes that lie in the middle). Broad generalisations are dangerous but our interpretation of the literature is that there are significant costs associated with currency overvaluation. These are that devaluation is an effective policy tool for realigning currencies and altering relative prices, and that the relevant foreign trade price elasticities are high enough to make devaluation work to strengthen the current account, albeit with a lag; that although devaluation does increase the domestic price level, the inflationary consequences of it can be easily overstated, especially if devaluation is accompanied by appropriate fiscal and monetary policies; that although, in some circumstances, there can be significant contractionary effects and adverse effects

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on the domestic financial sector, again these can be moderated by other appropriate policies. Large sample regression studies have also identified inertia in devaluation decisions and have found that the probability of devaluation varies according to the stage of the electoral cycle when allowing for other factors. There is therefore empirical support for the claim that delays in devaluation are often politically motivated. Research is only at an early stage, however, in determining the importance of different types of political–economic interactions under different circumstances. For example, some recent studies have emphasized distributional considerations while others have emphasized time asymmetries or election cycles (for example, Blomberg et al. 2005, Laban & Sturzenegger 1994, Klein & Marion 1997, Spolaore 2004 and Stein & Streb 2004). In this section we make no pretence to try to sort out these issues of relative importance, but rather offer commentaries on some recent episodes that illustrate the likely relevance of some of the considerations that we have discussed (for a further discussion of delayed devaluation in the case of the CFA franc zone which touches on similar issues, see Bird 1998). In the case of the United Kingdom’s eventual withdrawal from the Exchange Rate Mechanism of the European Monetary System in 1992 and the associated devaluation of sterling, key governmental concerns seem to have surrounded the inflationary consequences, the loss of face and the vulnerability to accusations of economic mismanagement to which the government would have been exposed, as well as the political constraint imposed by membership of an exchange rate union. There was also the hope that something would turn up in the form of persuading Germany to modify its policies and allow interest rates to fall. Pressure from UK exporters was present at the time, arguing that sterling was overvalued, but the pressure was not strong enough to precipitate devaluation. In the classic style of second generation crisis models, devaluation could eventually be no longer delayed once reserves began to plummet and the domestic costs of maintaining the currency’s value, in terms of high interest rates, lower economic growth and higher unemployment, became perceived as being too high politically. In the case of Mexico in 1994, there were again fears of inflation since, as in the UK case, the pegged exchange rate regime had been used as a counter-inflationary anchor. Indeed the value of the peso was put forward to the public as the centrepiece of Mexico’s economic strategy. Backed by


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prudent monetary and fiscal policies the stabilisation programme was successful in bringing inflation down from triple to single digits. After several years Mexico switched from a fixed peg to a crawling band regime, but concern for effects on wage settlements kept the rate of depreciation quite low while the current account deficit swelled. For a period, however, this deficit was fully financed by private capital inflows so there was considerable disagreement among economists over whether or not there was a fundamental disequilibrium. Unlike the UK, a substantial proportion of sovereign Mexican debt had been denominated in US dollars to try and signal to markets the government’s commitment to defend the currency. Once the debt was incurred, however, it became a hurdle to devaluation. Furthermore, and again like the UK, Mexico did not want to appear to be seeking an ‘unfair’ competitive advantage. Mexico’s government was acutely aware of the considerable hostility to closer North American integration that existed in the United States. In Thailand and several other Asian economies in the mid-1990s, concern about the balance sheet effects of devaluation was an important factor in discouraging devaluation, even as the current account deficit mounted. High interest rates in Thailand had combined with widespread perceptions that large depreciations would not be allowed by the government and this led to huge amounts of unhedged foreign borrowing. With growing recognition of weaknesses in the financial sector officials feared that a devaluation would impose huge costs on the domestic economy. Increasing this tendency to delay was the relatively weak position of the Thai government in a political system with a large number of veto players. The result was continued delay until the country (almost literally) exhausted all of its international reserves. Part of the Bank of Thailand’s strategy for buying time had been to protect measured reserves by sales in the forward market so that while published reserves were around US$30 billion, usable reserves net of forward sales fell to only a few billion before the baht was devalued. Argentina’s experience in the early 2000s shares some similarities with that of the UK a decade earlier, although in Argentina’s case the crisis was both a fiscal and a currency crisis. Initially Argentina’s currency board was a great success; it stopped high inflation and was accompanied initially by substantial economic growth. This period of monetary discipline, however,

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was not used to impose fiscal discipline and the Argentine government became the largest sovereign debtor on the global financial markets. As the 1990s continued these fiscal problems were joined by the appreciation of the US dollar to which the peso was fixed and then the economic crisis in its large neighbour Brazil. As the global financial markets and the IMF began to recognise these problems and Argentine debt lost its privileged place amongst international investors, the Argentine government seemed to enter progressively and strongly into denial. Because of the perverse fiscal structure of Argentina much of the aggregate fiscal deficit was run by the provinces over which the central government had little control. Admittedly devaluation for Argentina would have been more costly than in the ‘typical’ case, because of the strong commitment to fixity implied by the adoption of the currency board and the association of this in the minds of the public with avoiding the damage of previous hyperinflation. As the economy slipped into recession, tightening macroeconomic policy became more economically costly and politically difficult. The government’s main strategy appeared to be to continue to lobby for increasing amounts of IMF funding and to hope that the US dollar would depreciate and commodity prices would rise. The crisis which eventually made devaluation unavoidable occurred before these things happened.

The political economy of revaluation In the preceding sections we have argued that delayed devaluation can be explained in political economy terms. Are there reasons to believe that governments will be equally reluctant to revalue? Surely arguments used against devaluation can be re-used in favour of revaluation? If, for example, devaluation is postponed because certain groups believe they lose from it, they will also surely believe that they gain from revaluation? Indeed, to a certain extent, this line of thought is legitimate. If elasticity pessimism is an argument against devaluation, it may be an argument in favour of revaluation. The main difference between devaluation and revaluation, however, relates to the relevant constraints. There will be a constraint on how long devaluation can be postponed imposed by reserve holdings and access to borrowing. There will be no such constraint on how long revaluation can be delayed. In circumstances where a country favours export led growth, intervenes in the foreign exchange market, builds up reserves and


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is able and willing to sterilise the domestic monetary ramifications of the intervention, there may be little domestic motivation to revalue – as can be seen in the case of China in the late 2000s. There may therefore be even greater delay in revaluing than in devaluing.

Concluding remarks Experience suggests that governments are often reluctant to devalue even in circumstances where there is a broad consensus that the exchange rate is overvalued. Given the importance attached to having an equilibrium exchange rate, why do countries seek to avoid making an adjustment? Economic analysis by itself struggles to find a strong rationale for the delay. The discussion in this article suggests that it is the interaction between economic and political factors that exerts an important influence. While there may not be a unique political economy theory, political factors need to be taken into account if an adequate explanation of delay is to be provided. They will help explain why there will be a bias against devaluation. The most desirable way to correct the various biases discussed here is to develop well-informed officials and general publics who adopt longer term horizons and recognise better the costs of postponing necessary adjustments. We can also hope for improvements in economic and financial analysis that will firstly help us to discriminate better between temporary disequilibria that do not require adjustment, and longer term payments imbalances that do, and secondly help in estimating equilibrium exchange rates. But hopes may be frustrated. As a consequence, the prospects for operating adjustable peg regimes in a stable manner that avoids currency misalignment may not appear bright. An important key to preventing currency crises is to maintain consistency between exchange rate and domestic macroeconomic policy. Logically this does not require a ‘corner solution’ of completely fixed exchange rates where macro policy does all of the adjustment or a free float where the exchange rate does it all. Any combination of the two is technically feasible. The problem is that in the short term adjusting neither is often the politically dominant strategy. Where disturbances are temporary this can be good economic policy as well. But where disequilibria persist, biases toward delayed adjustment can prove to be costly.

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As capital mobility grows, the problem of policy inertia becomes greater since speculators will exploit it; a factor that has contributed to the frequency of currency crises. While adjustable pegs may work satisfactorily for low income countries that are not fully integrated into the international financial system, for many countries movements towards greater financial liberalisation should be accompanied not only by appropriate measures designed to impose prudential regulation and supervision, but also by moves toward greater exchange rate flexibility. The argument here is not for free floats, but rather for enough flexibility through managed floats or crawling bands to help offset political biases toward inaction and to reduce perverse incentives for excessive unhedged foreign currency borrowing. An important complement in the absence of ideal political conditions is to implement institutional reforms that allow economic policy officials to set policies based on the long-term economic considerations rather than short-term political ones. The case for independent central banks with respect to monetary policy is well developed (although not entirely free from concerns about accountability). Inflation targeting can then be used as an alternative to a pegged exchange rate as a means of anchoring inflationary expectations. Less well recognised is the case for allowing independent central banks to have similar responsibility for exchange rate policy, and thereby institutionally internalise the trade-off between exchange rate policy and monetary policy. In principle, this could go a significant way towards reducing the problem of excessively delayed macroeconomic adjustment. References Alesina, A. & Drazen, A. (1991) Why Are Stabilizations Delayed? American Economic Review, 81, 5, pp. 1170–1188. Alesina, A. & Roubini, N. with Cohen, G. D. (1997) Political Cycles and the Macroeconomy. Cambridge, MA: MIT Press. Bird, G. (1998) Exchange rate policy in developing countries: what is left of the nominal anchor approach? Third World Quarterly, 19, 2, pp. 255–276. Bird, G. (2002) Where Do We Stand on Choosing Exchange Rate Regimes in Developing and Emerging Economies? World Economics, 3, 1, pp. 145–166.


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Graham Bird & Thomas D. Willett Bird, G. & Rajan, R. (2004) Does devaluation lead to economic recovery or economic contraction? Theory and policy with reference to Thailand. Journal of International Development, 16, 2, pp. 141–156. Blomberg, S.B., Frieden, J. &. Stein, E.H. (2005) Sustaining fixed rates: the political economy of currency pegs in Latin America. Journal of Applied Economics, 8, 2, pp. 203–225. Cooper, R.N. (1971) Currency Devaluation in Developing Countries. Princeton Essays in International Finance, No. 86, June. Drazen, A. (1996) The Political Economy of Delayed Reform. Journal of Policy Reform, 1, 1, pp. 25–46. Drazen, A. (2000) Political Economy in Macroeconomics. Princeton, NJ: Princeton University Press. Edwards, S. (1989) Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries. Cambridge, MA: MIT Press. Fernandez, R. & Rodrik, D. (1991) Resistance to reform: status quo bias in the presence of individual specific uncertainty. American Economic Review, 81, December, pp. 1146–1155. Frankel, J. (1999) No single currency regime is right for all countries or for all times. Princeton Essays in International Finance, No. 214, August. Hamann, A.J. (2001) Exchange rate-based stabilization: a critical look at the stylized facts. IMF Staff Papers, 48, 1, pp. 111–138. International Monetary Fund (2006) Exchange rates and trade balance adjustment in emerging market economies. Washington, DC: IMF. Isard, Peter (2007) Equilibrium exchange rates: assessment methodologies. IMF working paper WP/07/296. Kamin, S.B. (1988) Devaluation, External Balance and Macroeconomic Performance: A Look at the Numbers. Princeton Studies in International Finance, No. 62, August. Klein, M. & Marion, N. (1997) Explaining the duration of exchange rate pegs. Journal of Development Economics, 54, 2, pp. 387–404. Laban, R. & Sturzenegger, F. (1994) Distributional conflict, financial adaptation and delayed stabilization. Economics and Politics, 6, 3, pp. 257–276.

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Why do Governments Delay Devaluation? Leblang, D. (1999) Democratic political institutions and exchange rate commitments in the developing world. International Studies Quarterly, 43, 4, pp. 599–620. Leblang, D. (2003) To devalue or to defend: the political economy of exchange rate policy in the developing world. International Studies Quarterly, 47, 4, pp. 533–559. Persson, T. & Tabellini, G. (2000) Political Economics: Explaining Economic Policy. Cambridge, MA: MIT Press. Rebelo, S. & Vegh, C.A. (2008) When is it optimal to abandon a fixed exchange rate? Review of Economic Studies, 75, 3, pp. 929–955. Spolaore, E. (2004) Adjustments in different government systems. Economics and Politics, 16, 2, pp. 117–146. Stein, E. &. Streb, J.M. (2004) Elections and the timing of devaluations. Journal of International Economics, 63, 1, pp. 119–145. Sturzenegger, F. & Tommasi, M. (1998) The Political Economy of Reform. Cambridge, MA: MIT Press. Willett, T.D. (2007) Why is the middle unstable? The political economy of exchange rate regimes and currency crises. The World Economy, 30, 5, pp. 709–732. Willett, T.D. (2006) Optimum currency area and political economy approaches to exchange rate regimes: towards a framework for integration. Current Politics and Economics in Europe, 17, 1, pp. 25–52. Willett, T.D. (2003) Fear of floating needn’t imply fixed rates: an OCA approach to the operation of stable intermediate currency regimes. Open Economies Review, 14, 1, pp. 71–91. Williamson, J. (2000) Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option. Washington, DC: Institute for International Economics.


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