The political economy of exchange rate regimes in developed and developing countries

European Journal of Political Economy 28 (2012) 38–53

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European Journal of Political Economy j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e j p e

The political economy of exchange rate regimes in developed and developing countries Aziz N. Berdiev a, Yoonbai Kim b, Chun Ping Chang c,⁎ a b c

Department of Economics, Bryant University, Smithfield, RI 02917, USA Department of Economics, University of Kentucky, Lexington, KY 40506, USA Department of Marketing Management, Shih Chien University at Kaohsiung, Kaohsiung, Taiwan

a r t i c l e

i n f o

Article history: Received 26 October 2010 Received in revised form 16 June 2011 Accepted 18 June 2011 Available online 25 June 2011 JEL classifications: F6 H8

Keywords: Political economy Exchange rate regimes Panel multinomial logit model

a b s t r a c t This paper examines the influence of government ideology, political institutions and globalization on the choice of exchange rate regime via panel multinomial logit approach using annual data over the period of 1974–2004 in a panel of 180 countries: 26 developed and 154 developing. We provide evidence that government ideology, political institutions and globalization are important determinants of the choice of exchange rate regime. In particular, we find that leftwing governments, democratic institutions, central bank independence and financial development increase the likelihood of choosing a flexible regime, whereas more globalized countries have a higher probability of implementing a fixed regime. More importantly, we find that political economy factors have different effects on the choice of exchange rate regime in developed and developing countries. All our results are robust to panel ordered probit model. © 2011 Elsevier B.V. All rights reserved.

1. Introduction The economic and political science literature emphasizes that political parties promote and advance policies in conformity with their ideology (Hibbs, 1977). Pearce (2006) explains that “governments may begin with an ideology and part of that ideology translates into policy proposals (p. 155).” In this context, political parties favor the “inherent effects of their policies and that parties have different objectives and incentives (Alesina, 1987:652).” The influential work of Hibbs (1977) first documented that left-wing governments favor relatively low unemployment, and, in turn, tolerate high rates of inflation in order to maintain low rates of unemployment. In contrast, right-wing governments prefer moderately low inflation at the expense of high rates of unemployment. In this line, left-wing parties are more averse to unemployment and less averse to inflation than the right-wing parties (Alesina, 1987). Thus, a large strand of literature has been devoted into understanding the nature and significance of government ideology in economic policy. The principal role of government in the economy is an underlying discord between right-wing and left-wing parties (Potrafke, 2010a). Right-wing governments favor protection of property rights and legal quality, while left-wing governments prefer government intervention in the economy (Bjørnskov, 2005a). Several papers, including the works of Bortolotti et al. (2003) and Potrafke (2010a), for example, explain that right-wing governments are associated with the privatization and deregulation processes to expand the support for market-oriented reforms. 1 More explicitly, market-oriented and right-wing parties promote economic freedom and prefer minimum government involvement in the economy. The empirical works of

⁎ Corresponding author. Tel.: + 886 7 6678888 5713; fax: + 886 7 6679999. E-mail address: [email protected] (C.P. Chang). 1 Benoit and Laver (2006) indicate that right-wing parties approve significantly more policies on deregulation, compared to left-wing governments. 0176-2680/$ – see front matter © 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2011.06.007

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Duso (2002), Pitlik (2008), Bortolotti and Pinotti (2008), Bjørnskov and Potrafke (2011) and Potrafke (2010a) demonstrate that market-oriented and right-wing governments promote and advance privatization, liberalization and deregulation processes. Recently, exchange rate regime determination has received noteworthy academic research and discussion. The type of exchange rate regime provides essential consequences for price stability, international trade and monetary policy (Frieden et al., 2010). Thus, an extensive literature provides considerable evidence that government ideology influences the exchange rate policies. More precisely, government ideological differences across political parties create diverse attitudes in regards to policy, and, in turn, play a critically important role in determining the choice of exchange rate regime. For instance, when right-wing governments are assumed to favor low inflation, they may choose fixed exchange rate regime in order to create monetary stability; and, in turn, generate low rates of inflation (Frieden and Stein, 2001; Broz and Frieden, 2001; Levy-Yeyati et al., 2010; Frieden et al., 2010). In a similar notion, when left-wing governments are assumed to prefer relatively low unemployment and high output, they may favor the flexible exchange rate regime to manage independent monetary policy in order to achieve its macroeconomic objectives (Broz and Frieden, 2001; Frieden et al., 2010). In addition, the theoretical consideration of Milesi-Ferretti (1995) illustrates that a right-wing government may abstain from choosing a fixed exchange rate regime with the intention of benefiting from inflationary reputation policies of the left-wing government. Bodea (2010), who expands on the work of Milesi-Ferretti (1995), suggests that right-wing governments are typically more inclined to realign fixed exchange rates. The fundamental argument is that market-oriented governments (rightwing) favor the fixed exchange rate regime in the choice of exchange rate system, while the intervened-oriented governments (left-wing) prefer a flexible exchange rate regime. Yet, Klein and Schambaugh (2010) emphasize that the proposition that rightwing parties advance and promote the fixed exchange rate regime is not supported by many empirical studies, and, therefore, generated mixed results. Despite the great deal of academic research and discussion, the influence of government ideology on exchange rate regime choice is not straightforward, and empirical studies often produce contradictory findings. 2 Earlier empirical literature has generated inconsistent results regarding the effect of ideology on the exchange rate regime, which we believe are obscured by the various econometric techniques, the choice of explanatory variables that impact exchange rate regime determination and further mitigating factors such as the linkage of exchange rate regime choice to other policies. Hence, the goal of the present paper is to examine the impact of government ideology, political institutions and globalization on the choice of exchange rate regime a country implements. The present paper contributes to the existing literature on the effects of government ideology, political institutions and globalization on the choice of exchange rate regime along several dimensions. First, we ask, does government ideology influence the choice of exchange rate regime? A review of the literature suggests that governments prefer a fixed exchange rate regime to create monetary stability, which is generally associated with low rates of inflation (Frieden and Stein, 2001; Broz and Frieden, 2001; Levy-Yeyati et al., 2010; Frieden et al., 2010). Alternatively, the foremost benefit of a flexible exchange rate regime is to allow the government to conduct independent monetary policy (Broz and Frieden, 2001). Given that policymakers have systematically different preferences regarding macroeconomic objectives and differ in their valuation of growth, employment and price stability, policymakers may choose the exchange rate regime that conforms to their political orientation. In the interest of robustness, we use three measures of government ideology in our empirical analysis. In particular, we follow the methodology in Dreher et al. (2010) and Bjørnskov (2005b, 2008) by employing the national election results characterized in the Beck et al. (2001) Database of Political Institutions, which classifies the three largest government parties according to whether they have a left-wing, centrist or right-wing ideological orientation. Second, we examine the impact of political institutions, central bank independence and electoral motives on the type of exchange rate regime a country implements. While government ideology is one factor that can influence the choice of exchange rate policy, it may also be the case that political institutions impact the exchange rate regime determination. 3 For example, democratic institutions facilitate greater information and render credible signal about policy objectives to the public than nondemocracies (Fearon, 1994; Broz, 2002). Perhaps not surprisingly, politicians in democratic institutions incur demands to employ more redistributive policies than politicians in authoritarian countries (Leblang, 1999). As such, democratic institutions may implement a flexible exchange rate regime in order to allow the government to conduct monetary policy toward domestic stabilization purposes. Further, the work of Pissarides (1980) explains that governments may potentially strive to control the economy to make them a more “popular party.” In a similar notion, Bernhard and Leblang (1999) emphasize that policymakers are disinclined to relinquish any policy instruments that can facilitate them in gaining office. That is, policymakers may influence the exchange rate regime before the elections to facilitate output growth in order to increase their probability of reelection. Thus, prior to elections, policymakers may choose the flexible exchange rate regime to allow the government to conduct monetary policy to achieve employment growth to facilitate their likelihood of reelection. Nevertheless, a credible independent central bank predictably has the ability to oppose pressures from policymakers (Klein and Schambaugh, 2010). That is, a high level of central bank independence considerably constrains the authority of policymakers to guide monetary policy for electoral intentions (Clark et al., 1998). The purpose for appointing monetary policy to a credible independent central bank is to eliminate political conflict over 2

For a detailed literature review, see Broz and Frieden (2001). We construct our discussion on democracies and nondemocracies in the analysis of domestic political institutions. A similar body of research has examined the effect of political strength on the choice of exchange rate regime (Frieden and Stein, 2001; Hossain, 2009; Levy-Yeyati et al., 2010). 3

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monetary policy decisions (Crowe, 2008). In addition, central bank independence combined with a flexible exchange rate regime delegates the accountability for monetary policy decisions exclusively to the central bank in order to promote policy independently without government intervention (Siklos, 2008). Third, we investigate the influence of globalization on the choice of exchange rate regime. The process of globalization, which integrates the world economy into a single system, may also affect the choice of exchange rate policy. 4 We follow the work of McKinnon (1963), who emphasized that “openness” is an essential factor that influences the choice of exchange rate regime a country implements. More recently, Frieden (2008) argues that the process of globalization intensifies the importance of the exchange rate regime. Many countries have attempted to facilitate economic integration via trade agreements to liberalize commercial flows through reduction in tariffs. Concurrently, advancement in technology is facilitating improvement in the flows of information and of goods and services. These movements are promoting the stability and growth of an economy by creating greater efficiency in coordination and reducing the costs of transaction and transportation. In this regard, international capital mobility and global integration has challenged the ability of governments to enact national policy. Hence, open economies, which are globally integrated countries, may favor exchange rate policy that reduces risks associated with exchange rate variability that could potentially deter international trade and investment. Finally, we explore the choice of exchange rate regime determination in an unbalanced panel of 180 countries: 26 developed and 154 developing. We uncover several interesting differences in the choice of exchange rate regime in developed and developing countries. We also integrate further explanatory variables for efficient estimations results. More specifically, we incorporate explanatory variables such as the level of financial and economic development, inflation and lending interest rates. We examine the determinants of exchange rate regime via panel multinomial logit approach with fixed-effects model, where countries are allowed to choose among the exchange rate regimes. We employ panel data analysis to account for the presence of heterogeneity in the estimated parameters and dynamics across countries (Baltagi, 1995). The analysis is based upon data recorded annually over the period of 1974–2004. We utilize the de facto classification of exchange rate regime, developed and constructed by Levy-Yeyati and Sturzenegger (2005), which represents the actual classification of exchange rate regime rather than announced policies. We also estimate ordered probit model to further support the robustness of our results. Overall, we provide robust evidence that government ideology, political institutions and globalization are important determinants of the choice of exchange rate regime. In particular, we find that a left-wing government is more likely to adopt a flexible regime and less likely to implement a fixed regime. Further, we provide evidence that democratic institutions have a higher probability of choosing a flexible regime. Similarly, we also discover that politicians have a higher probability of choosing a flexible regime prior to elections. Also, central bank independence is associated with a flexible regime. More globalized countries are more likely to choose a fixed regime and no significant effect on choosing a flexible regime. More importantly, we find that political economy factors have different effects on the choice of exchange rate regime in developed and developing countries. In particular, we display that a left-wing government is more likely to choose a flexible regime in developing countries, however, no significant effect of choosing a flexible regime in developed countries. Also, our findings suggest that more globalized countries in developed economies favor a fixed regime, whereas developing economies prefer a flexible regime. Further, greater financial development in developed countries increases the probability of a flexible regime, though developing countries are more likely to choose a fixed regime. The remainder of the paper is structured as follows. In Section 2, we discuss the determinants of exchange rate regime in accordance with the previous literature. Section 3 details the econometric methodology employed in the investigation and describes the data. Section 4 presents the empirical results. The final section summarizes the major findings.

2. Determinants of exchange rate regimes Previous literature has emphasized that right-wing and left-wing governments differ in their preferences regarding output, employment and price stability: right-wing governments favor moderately low rates of inflation, whereas left-wing governments prefer relatively low unemployment (Hibbs, 1977; Alesina, 1987). In this context, governments favor a fixed regime to generate monetary stability, which is generally associated with low rates of inflation (Frieden and Stein, 2001; Broz and Frieden, 2001; Levy-Yeyati et al., 2010; Frieden et al., 2010). This effect transpires via two channels: fixed exchange rates (1) create obstacles for the prices in the tradable sector to increase without attracting rival imports, and (2) function as a strong signal of government objectives, as politicians “tie their own hands as a commitment device (Frieden and Stein, 2001:3).” On the latter channel, policymakers implement a fixed regime to signal their commitment to price stability and convincingly reveal to the public that their hands are tied (Eichengreen and Leblang, 2003; Frieden et al., 2010). 5 Further, governments who favor low inflation may choose a fixed regime with the purpose of eliminating monetary policy (Frieden et al., 2010). Governments must, on the other hand, relinquish their ability to conduct an independent monetary policy by choosing the fixed exchange rate regime (Broz and Frieden, 2001). 6 As a result, an economy with international capital mobility 4 Petras and Veltmeyer (2001) explain that globalization represents the process of “widening and deepening of the international flows of trade, capital, technology and information within a single integrated market (p. 11).” 5 Levy-Yeyati et al. (2010) also explains that governments experiencing difficulties of persuading the public of their promise to price stability may use a fixed regime to reduce uncertainty and contain inflationary anticipations. 6 The principle of the “impossible trinity” suggests that a fixed regime and independent monetary policy are not concurrently achievable in the presence of capital mobility.

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that chooses a fixed regime causes monetary policy to be ineffective. However, attaining monetary stability is a considerable advantage for governments with a preference for price stability. Thus, when the right-wing governments are assumed to favor low inflation, they may choose a fixed regime in order to create monetary stability, and, in turn, generate price stability. Alternatively, the fundamental benefit of a flexible regime is to allow the government to conduct its own independent monetary policy (Broz and Frieden, 2001). Monetary policy has significant influence on the level of employment and income because it stimulates capital outflow, depreciate the real exchange rate and generates trade surplus (Mundell, 1963). For example, high levels of capital flows could potentially appreciate the real exchange rate, generating a shift of resource allocation from the tradable to the nontradable sector of the economy. Thus, a large influx of capital may generate movement of resources – labor and production – from the tradable to the nontradable sector of the economy, deteriorating the international competitiveness of an economy (Edwards, 1998). A flexible regime permits the government to regulate the nominal exchange rate to assure the competitiveness in the tradable sector (Broz and Frieden, 2001). In this line, when the left-wing governments prefer relatively low unemployment and high output, they may favor a flexible regime to manage independent monetary policy. However, a left-wing government that implements a flexible regime has smaller credibility gains (Broz and Frieden, 2001). Therefore, it is likely that a left-wing government may choose a fixed regime because it experiences greater credibility problems (Milesi-Ferretti, 1995; Bodea, 2010). It is also important to note that the choice of exchange rate regime influences fiscal policy (Markiewicz, 2006). For example, according to the Mundell–Fleming model, a small open economy with relatively free capital mobility that chooses a fixed regime generates greater independence to conduct fiscal policy. Nevertheless, a fixed regime commands that the government counter to exogenous shocks and entails that fiscal policy be under control (Frieden and Stein, 2001). 7 When the economy experiences an unfavorable disturbance, such as a movement in international demand away from the goods it produces, monetary policy becomes ineffective (Frankel and Rose, 1996). Hence, countries may potentially experience unwarranted welfare losses in employment and output without the ability to employ monetary policy to neutralize localized economic shocks (Bernhard and Leblang, 1999). However, it is also possible that a left-wing government may approve marketoriented policies, when challenged with the reality that such reforms are necessary, and credibly convince the public of the importance of these changes (Cukierman and Tommasi, 1998). Thus, under these conditions, a left-wing government may potentially be able to credibly commit to a fixed regime. The configuration of domestic political institution also has significant influence on the type of exchange rate regime a country chooses (Bernhard and Leblang, 1999; Hossain, 2009; Frieden et al., 2010). Democratic institutions facilitate greater information and render credible signal about policy objectives to the public than nondemocracies (Fearon, 1994; Broz, 2002). Hence, governments in democratic institutions face pressures for expansionary monetary policy, and experience higher domestic political costs.8 In this line, democratic institutions are more likely to implement a flexible regime to allow the government to conduct monetary policy toward domestic stabilization purposes (Leblang, 1999). Broz (2002) argues that democracies declare a flexible regime, provided that they are more transparent and politically accountable institutions. 9 In a similar notion, Frieden and Stein (2001) explain that dictatorship and authoritarian countries are more likely to employ the necessary instruments to sustain a fixed regime. 10 The political business cycle literature emphasizes that policymakers may use the exchange rate regime to achieve short-term macroeconomic objectives prior to elections (Clark et al., 1998; Bernhard and Leblang, 1999; Carmignani et al., 2008; Hossain, 2009). Prior to elections, it is challenging for governments to maintain a fixed regime due to pressures toward greater expansionary policy (Carmignani et al., 2008). That is, policymakers are disinclined to relinquish any policy instruments that can facilitate them in gaining office (Bernhard and Leblang, 1999). Pissarides (1980) argues that voters increase their support for policymakers if they are successful in pursuit of price stability and employment growth. Thus, when elections approach, policymakers may choose the flexible regime to allow the government to manage independent monetary policy to realize shortterm output growth and low rates of unemployment with the intention of winning the election (Hossain, 2009). Nevertheless, policymakers cannot utilize macroeconomic conditions for electoral intentions when monetary policy is under the control of an independent central bank (Clark et al., 1998). An independent central bank may suggest to the public that monetary policy may be shielded from extreme government ideology (Bernhard and Leblang, 2002). As a result, central bank independence is a critically valuable commitment mechanism when accompanied with transparent and politically accountable institutions (De Haan et al., 2008). 11 Previous literature indicates that greater central bank independence generates price stability (Eijffinger and De Haan, 1996; Crowe and Meade, 2008; Jácome and Vázquez, 2008; Eijffinger and Hoeberichts, 2008). More importantly, a review of the literature suggests that substituting “exchange-rate based anchors” with central bank independence allows the use of monetary policy for domestic targeting (Cukierman, 2008). Crowe and Meade (2008) suggest that a shift to a more flexible regime is linked with greater central bank independence. 12 To sum, countries with greater central bank independence are more likely to implement a flexible regime. The process of globalization, which integrates the world economy into a single system, may also affect the choice of exchange rate policy. McKinnon (1963) explains that “openness” impacts the type of exchange rate regime a country employs. In addition, 7

Frieden and Stein (2001) suggest that weak governments are less likely to sustain a fixed regime. Fearon (1994) argues that governments suffer “audience costs” if they do not carry out the promised courses of actions. Kimakova (2008) also finds that a government with higher degree of accountability implements a flexible regime. 10 Frieden et al. (2010) indicates that policymakers in democratic countries may choose a fixed exchange rate regime to convincingly display to the public that their hands are tied in the analysis of 21 transition economies. 11 In fact, Crowe and Meade (2008) find that higher central bank transparency causes the private sector to produce more precise forecasts with the information granted by the central bank. 12 In addition, Berger et al. (2008) explain that countries with a flexible regime have larger monetary policy committees. 8 9

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Frieden (2008) emphasizes that global integration enhances the significance of the exchange rate regime. For example, countries that significantly depend on trade – open economies – are more likely to implement a fixed exchange rate regime because it reduces the volatility of exchange rates and transaction costs (Broz and Frieden, 2001). As a result, international partners have a stable and predictable trading environment, thereby leading to greater cross-border economic interests and higher growth in investment (Bernhard and Leblang, 1999). Alternatively, flexible regimes generate exchange rate variability, and, in turn, produce unpredictability about international transactions and enhance risk premium to the costs of assets in cross-border trade (Broz et al., 2008). Thus, we argue that more globalized countries may favor a fixed exchange rate regime in order to lower risks associated with exchange rates that could potentially deter international trade and investment. The structure of the financial system is also fundamentally important for the choice of exchange rate regime. Hossain (2009) indicates that the development of the financial system is imperative for the choice of flexible regime. Since the process of financial development decreases the usefulness of capital controls, Markiewicz (2006) explains that the principle of “impossible trinity” is between independent monetary policy and exchange rate stability. Hence, countries with low financial development select a fixed regime because they (1) do not have proper market tools to operate domestic open market operations (Markiewicz, 2006) and (2) need to protect their inexperienced banking sector from exchange rate volatility (von Hagen and Zhou, 2005). Hence, we anticipate that countries with greater financial development are more likely to choose a flexible exchange rate regime. According to McKinnon (1963), economic size is also a crucial determinant of a choice of exchange rate regime. Smaller economies favor a fixed regime because they are inclined to have high rates of participation in international trade (Markiewicz, 2006). In other words, countries with higher level of economic development increase the probability of employing a flexible regime (Poirson, 2001; Hossain, 2009). We also anticipate that the level of domestic interest rates affect the mobility of international capital flows, and, in turn, to impact the exchange rate regime determination. Markiewicz (2006) explains that an increase in the domestic interest rates may lead a country to choose a fixed regime due to elevated financial costs for the government. Finally, high rates of inflation may potentially weaken the international competiveness of an economy (Bodea, 2010). Thus, economies that experience high rates of inflation may possibly choose a fixed regime to reduce inflation, thereby rebuilding competitiveness in the tradable sector (Frieden and Stein, 2001). 3. Methodology and data 3.1. Econometric model We employ a panel multinomial logit approach with fixed effects model due to the nature of the dependent variable. 13 The dependent variable is categorical variable that classifies the de facto exchange rate regime. The probability that the government i will choose the exchange rate regime j classification (Pij) is distributed as follows:   Pitj = Pr Yitj N Yitk ; for k ≠ j; j = 1; ⋯n:

ð1Þ

Eq. (1) denotes the unobserved utility that government i derives in year t from regime j, where Yij represents maximum utility achieved from exchange rate regime for government i if the government chooses the j-th exchange rate regime classification. In addition, 0

Yij = α + βj Xij + ηi + εij

ð2Þ

where the dependent variable Y is the exchange rate regime classification. We define the fixed exchange rate regime as the baseline category. βj is a vector of coefficients of each of the independent variables X, which are estimated via maximizing a log likelihood function. The stochastic terms εij has the independent and Weibull distribution and ηi is an individual-specific, timeinvariant effect. The multinomial logit model can be expressed as follows: 0

0

Pij = expðβj Xij Þ = Σexpðβj Xij Þ:

ð3Þ

The multinomial logit regression is the most suitable model in a discrete choice analysis in a presence of more than two alternatives in a choice set. The multinomial logit model is employed to examine the relationship between a categorical response variable, with more than two categories, and a set of explanatory variables (So and Kuhfeld, 1995). It is derived from the theory of maximum random utility that states that a government implements an exchange rate regime which maximizes its utility in the exchange rate regime selection. Under these conditions, a country may choose among several alternatives (different exchange rate regimes) as a function of a decision maker (government) and decision (exchange rate regime) attributes. An important assumption of the multinomial logit model is that it implies that the decision between two different sets of alternatives is independent from the presence of more alternatives. Further, it provides useful information in determining the correct type of model to estimate multinomial logit equations. Wei et al. (2005) employ a multinomial logit model to investigate the entry modes 13 The fixed-effects model calculates means for each variable and then subtracts the means; the constant and individual effects are also eliminated by this transformation eliminating unobserved heterogeneity by taking deviations from individual means periods.

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of foreign direct investment in China. Also, Levy-Yeyati et al. (2010) utilize a multinomial logit approach to test the endogeneity of exchange rate regimes. 3.2. Data analysis The definitions, data sources and summary statistics for all the variables are reported in Table A1. We investigate exchange rate regime determination in a panel of 180 countries: 26 developed and 154 developing countries. The list of countries is reported in Table A2. The analysis is based upon data recorded annually over the period of 1974–2004. The data are extracted from several sources, namely Levy-Yeyati and Sturzenegger (2005), Klomp and De Haan (2009), Cheibub et al. (2010), World Bank’s World Development Indicators (20209), 2011 KOF Index of Globalization (Dreher, 2006, updated in Dreher et al., 2008), Database of Political Institution (2010) and the Democracy Cross-national Data: Pippa Norris. 3.2.1. The dependent variable: the de facto exchange rate regime The dependent variable is exchange rate regime, more specifically, the de facto exchange rate regime constructed by Levy-Yeyati and Sturzenegger (2005). The fundamental advantage of de facto exchange rate regime classification is that it represents the actual classification of exchange rate regime rather than announced policies. Levy-Yeyati and Sturzenegger (2005) classify de facto exchange rate regimes in accordance with the performance of three classification variables: (a) exchange rate volatility, (b) volatility of exchange rate changes and (c) volatility of international reserves. In what follows, we briefly define these classification variables, as detailed in Levy-Yeyati and Sturzenegger (2005). Exchange rate volatility represents “the average of the absolute monthly percentage changes in the nominal exchange rate during a calendar year.” The volatility of exchange rate changes signifies “the standard deviation of the monthly percentage changes in the exchange rate.” The volatility of international reserves refers to the “changes in reserves that reflects intervention in the foreign exchange market”, which is computed by subtracting “government deposits at the central bank from the central bank’s net foreign assets.” Levy-Yeyati and Sturzenegger (2005) compute the three classification variables and employ cluster analysis as a technique to allocate data to different countries, thereby constructing the de facto exchange rate regime classification. 14 To ensure robustness of the empirical results, we use two exchange rate regime classifications: (1) exchange rate 3-ways classification (1 = float; 2 = intermediate; 3 = fix) and (2) exchange rate 5-ways classification (1 = inconclusive; 2 = float; 3 = dirty; 4 = dirty/crawling peg; 5= fix). Hence, our dependent variable is the de facto exchange rate regime 3-ways and 5-ways classification (idx3 and idx5, respectively). Levy-Yeyati and Sturzenegger (2005) explain that observations that exhibit little variability cannot be effectively designated to any specific regime, and, consequently, are categorized as “inconclusive”. Thus, we do not report the results for “inconclusive” in our empirical findings. 3.2.2. Explanatory variables The variable government ideology represents the ideological orientation of the respective government. We use three alternative measures of government ideology. 15 More specifically, we utilize the national election results characterized in the Beck et al. (2001) Database of Political Institutions, which classifies the three largest government parties according to whether they have a left-wing, centrist or right-wing ideological orientation. Our first measure of government ideology (ideology1) is obtained from Democracy Cross-national Data. Pippa Norris codes the variable executive party ideology for a country as follows: right-wing parties R, centrist parties C, and left-wing parties L. We follow the general approach in Dreher et al. (2010), and code left-wing governments 1 and 0 otherwise. On the second measure of government ideology (ideology2), we follow the methodology in Bjørnskov (2005b, 2008), and assign right-wing — 1, centrist 0, and left-wing 1, and weight single party ideologies with their proportion of seats in the parliament. Our last measure of government ideology (ideology3) is a 5-year moving average data of ideology2. The variables ideology2 and ideology3 represent the “self-professed relative ideology of governments (Bjørnskov, 2008:301).” For example, a “fully leftwing government throughout the period are assumed to have a population in which the majority has leftwing sympathies and ideology and which defines the policy set (Bjørnskov, 2008:301).” Our democracy data comes from Cheibub et al. (2010), who build on the work of Alvarez et al. (1996) and Przeworski et al. (2000), which define institutions as democracy according to whether the chief executive office and the legislative body are filled by contested elections. Hence, an institution is categorized as a democracy if it fulfills the following four conditions: (1) “the chief executive must be chosen by popular election or by a body that was itself popularly elected”; (2) “the legislature must be popularly elected”; (3) “there must be more than one party competing in the elections”; and (4) “an alternation in power under electoral rules identical to the ones that brought the incumbent to office must have taken place (Cheibub et al., 2010:69).” 16 Hence, the variable democracy is coded 1 if the respective government satisfies all the above requirements, 0 otherwise. We obtain the election data from International Institute for Democracy and Electoral Assistance. We adjust the electoral timing at a 1 year lag, since many policies are purposely promoted prior to the elections with the intention of reelection. Arnone et al. (2007) build central bank independence indicator based on the general approach of Grilli et al. (1991) that differentiates between

14

For an extensive analysis of exchange rate regime classifications, including construction and methodology, see Levy-Yeyati and Sturzenegger (2005). We acknowledge that government ideology is difficult to measure, especially in developing countries. Nevertheless, previous literature has utilized the work of Beck et al. (2001) Database of Political Institutions to investigate the significance of government ideology. 16 For an extensive analysis of the democracy data, including construction and methodology, see Cheibub et al. (2010). 15

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the political autonomy (the ability of the central bank to choose the objectives of monetary policy) and economic autonomy (the ability of the central bank to choose its instruments). Therefore, we use the central bank independence data from Klomp and De Haan (2009), who follow the information on central bank law reforms in Acemoglu et al. (2008) and determine the value of the central bank independence index for all the periods for which Arnone et al. (2007) supply data. 17 We utilize the overall globalization index (2011) originally developed by Dreher (2006), and further summarized by Dreher et al. (2008), who construct an index of globalization covering three main dimensions: economic, social and political integration. Economic globalization refers to “long distance flows of goods, capital and services as well as information and perceptions that accompany market exchanges.” Political globalization represents “diffusion of government policies.” Social globalization epitomizes the “spread of ideas, information, images, and people.” These sub-indexes are, in turn, aggregated into one single index of overall globalization. 18 Norris (2000) describes the process of globalization as eroding “national boundaries, integrating national economies, cultures, technologies, and governance, producing complex relations of mutual interdependence (p. 155).” We incorporate additional explanatory variables to obtain efficient estimation results. We follow previous literature and employ the real GDP (constant in 2000 and transformed in natural logarithms) to assess the level of economic performance in various countries, based on the World Bank’s World Development Indicators (WDI, 2009). We utilize the domestic credit to private sector as a percentage of GDP to proxy for financial development, lending interest rates to represent the domestic interest rates and annual percentage change of consumer prices to denote the inflation rate, also extracted from WDI (2009).

4. Empirical results To start, we investigate the relationship between our explanatory variables and the choice of exchange rate regime for the full sample. Table 1 displays the estimation results. Subsequently, we analyze the influence of our explanatory variables on the choice of exchange rate regime in our sample of developing and developed countries. Tables 2 and 3 report the empirical results. In the interest of robustness, we report the estimation results for the dependent variable de facto exchange rate regime 3-ways and 5ways classification (idx3 and idx5, respectively). We estimate a multinomial logit model with fixed-effects where the baseline category is a de facto fixed exchange rate regime. Hence, the parameters in Tables 1–3 demonstrate the impact of the independent variables on the marginal utility of the choice of exchange rate regime under consideration relative to the baseline category — the fixed exchange rate regime. Further, the statistical significance of a parameter denotes the degree to which the corresponding independent variable influences the marginal utility of the pertinent exchange rate regime relative to the baseline category — the fixed exchange rate regime.

4.1. Full sample Consider first the influence of government ideology on the choice of exchange rate regime for the dependent variable idx3 in Table 1 (columns I, II and III). All our measures of ideology have the expected positive and statistically significant coefficient in all equations, suggesting that a left-wing government is more likely to implement a flexible regime and less likely to adopt a fixed regime. Our results are in line with the notion that left-wing governments favor a flexible regime to conduct monetary policy to achieve employment growth. We provide evidence that policymakers choose the type of exchange rate regime that conforms to their political ideology since they have substantially different inclinations concerning macroeconomic objectives. As anticipated, our findings indicate that democratic institutions increase the probability of choosing a flexible regime. These results are also consistent with those of Leblang (1999) and Broz (2002). Further, central bank independence increases the probability of selecting a flexible regime and decreases the probability of selecting a fixed regime. These results are reinforced with those of Siklos (2008), who emphasizes that a flexible exchange rate regime delegates the responsibility for monetary policy decisions entirely to the central bank and highlights that a fixed exchange rate regime constraints the central bank to conduct monetary policy. Our findings also support the view that a shift to a more flexible exchange rate regime is associated with greater central bank independence (Crowe and Meade, 2008) and replacing “exchange-rate based anchors” with central bank independence allows the use of monetary policy for domestic targeting (Cukierman, 2008). In addition, the variable election has a positive and statistically significant coefficient, providing evidence that politicians increase the likelihood of implementing a flexible regime prior to elections. Our results are supported by the political business cycle literature, which emphasizes that policymakers influence the exchange rate regime before the elections to facilitate output growth in pursuit of electoral success. This is in line with the view that governments may potentially strive to control the economy to make them a more “popular party”, as documented by Pissarides (1980). More importantly, this is consistent with the analysis

17 We are grateful to Professors Jeroen Klomp and Jakob de Haan for providing us with the data. We also appreciate the advice from Professor Axel Dreher in handling this dataset. 18 It is important to emphasize that globalization is a multi-dimensional concept that cannot be described by a single indicator, i.e. trade openness and foreign direct investment (Simmons and Elkins, 2004; Potrafke, 2010b). Following previous studies, we emphasize that the overall globalization index is able to capture the multi-dimensional characteristics of globalization because it includes economic, social and political integration.

Table 1 Multinomial logistic regression estimates: full sample. Model

Dependent variable: idx3 I

Dependent variable: idx5

II

III

IV

V

VI

2

1

2

1

2

2

3

4

2

3

4

2

3

4

Ideology1

− 1.447⁎⁎ (− 8.531) 0.399⁎⁎

− 1.113⁎⁎ (− 6.178) 0.279⁎⁎

− 1.534⁎⁎ (− 8.743) –

− 1.167⁎⁎ (− 6.364) –

− 1.586⁎⁎ (− 9.251) –

− 1.236⁎⁎ (− 6.864) –

− 1.452⁎⁎ (− 8.535) 0.401⁎⁎

− 2.436⁎⁎ (− 9.404) 0.426⁎⁎

− 1.542⁎⁎ (− 8.763) –

− 2.425⁎⁎ (− 9.141) –

− 1.595⁎⁎ (− 7.114) –

− 1.598⁎⁎ (− 9.287) –

− 2.475⁎⁎ (− 9.474) –

− 1.681⁎⁎ (− 7.647) –

Ideology2

(3.312) –

(2.123) –

–

(3.324) –

(2.301) –

–

–

–

Democracy

0.307⁎⁎ (2.337) 0.002 (0.161) 0.960⁎⁎ (3.311) 0.258⁎

0.050 (0.367) − 0.023⁎ (− 1.869) 0.802⁎⁎ (2.525) 0.214 (1.472) 0.295 (1.048) − 0.001 (− 0.817) 0.001⁎ (1.713) − 0.001 (− 1.523)

0.494⁎⁎ (3.570) 0.003 (0.242) 1.091⁎⁎ (3.625) 0.286⁎⁎

0.088 (0.637) − 0.020 (− 1.587) 0.944⁎⁎ (2.861) 0.195 (1.320) 0.239 (0.833) − 0.001 (− 0.566) 0.001⁎ (1.842) − 0.001 (− 1.441)

0.307⁎⁎ (3.426) 0.130 (0.971) − 0.015 (− 1.258) 0.942⁎⁎ (2.910) 0.228 (1.576) 0.188 (0.670) − 0.001 (− 0.445) 0.001⁎ (1.830) − 0.001 (− 1.483)

0.271⁎⁎ (2.316) –

–

0.051⁎ (1.686) 0.532⁎⁎

0.371⁎⁎ (3.313) –

–

–

0.057⁎ (1.728) –

–

–

0.314⁎⁎ (3.274) –

–

Ideology3

0.056⁎ (1.650) –

− 1.505⁎⁎ (− 6.782) 0.219 (1.384) –

0.307⁎⁎ (2.338) 0.001 (0.068) 0.957⁎⁎ (3.291) 0.256⁎

− 0.140 (− 0.705) − 0.046⁎⁎ (− 2.554) 1.369⁎⁎ (3.054) 0.143 (0.684) − 0.199 (− 0.472) 0.004⁎ (1.765) 0.002⁎ (1.710) 0.001 (0.448)

0.154 (0.952) − 0.022 (− 1.506) 0.376 (0.977) 0.255 (1.480) 0.817⁎⁎

0.498⁎⁎ (3.598) 0.002 (0.142) 1.093⁎⁎ (3.628) 0.284⁎⁎

− 0.081 (− 0.403) − 0.043⁎⁎ (− 2.321) 1.466⁎⁎ (3.149) 0.109 (0.517) − 0.213 (− 0.501) 0.004⁎ (1.897) 0.002⁎ (1.839) 0.001 (0.389)

0.195 (1.167) − 0.020 (− 1.299) 0.547 (1.369) 0.244 (1.390) 0.757⁎⁎

0.052⁎ (1.768) 0.535⁎⁎

0.354⁎⁎ (3.308) 0.008 (0.042) − 0.035⁎ (− 1.959) 1.381⁎⁎ (3.018) 0.137 (0.660) − 0.227 (− 0.548) 0.004⁎ (1.846) 0.002⁎ (1.802) 0.001 (0.584)

0.282⁎⁎ (2.636) 0.204 (1.270) − 0.017 (− 1.165) 0.634 (1.619) 0.276 (1.611) 0.684⁎⁎

Globalization cbi Election rgdp Financial development Inflation Interest rate Log likelihood LR chi2 Pseudo R2

(1.943) − 0.521⁎ (− 1.935) 0.005⁎⁎ (3.392) − 0.001 (− 0.124) − 0.001 (− 0.574) − 1958.527 87.520 0.022

(2.125) − 0.473⁎ (− 1.705) 0.004⁎⁎ (2.680) 0.001 (0.082) − 0.001 (− 0.577) − 1889.920 106.640 0.027

(4.011) 0.002 (0.150) 1.072⁎⁎ (3.628) 0.299⁎⁎ (2.261) − 0.501⁎ (− 1.844) 0.004⁎⁎ (3.168) 0.001 (− 0.150) − 0.001 (− 0.522) − 1972.564 116.900 0.029

(1.929) − 0.517⁎ (− 1.912) 0.005⁎⁎ (3.419) − 0.001 (− 0.186) − 0.001 (− 0.908) − 2452.351 173.340 0.034

(2.398) − 0.003⁎ (− 1.715) − 0.002⁎⁎ (− 3.455) − 0.002 (− 1.266)

(2.113) − 0.465⁎ (− 1.669) 0.004⁎⁎ (2.684) 0.001 (0.020) − 0.001 (− 1.055) − 2372.364 192.530 0.039

(2.176) − 0.003 (− 1.514) − 0.002⁎⁎ (− 3.364) − 0.002 (− 1.414)

(4.039) 0.001 (0.011) 1.074⁎⁎ (3.633) 0.298⁎⁎ (2.256) − 0.489⁎ (− 1.793) 0.004⁎⁎ (3.201) − 0.001 (− 0.336) − 0.001 (− 0.967) − 2480.617 199.170 0.039

(2.004) − 0.003 (− 1.336) − 0.002⁎⁎ (− 3.441) − 0.002 (− 1.327)

A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

1 Constant

Notes: The dependent variable idx3 is a categorical variable that takes the value 1 if a country is classified as a de facto flexible exchange rate regime, 2 if intermediate and 3 if fixed. The dependent variable idx5 is a categorical variable that takes the value 2 if a country is classified as a de facto flexible exchange rate regime, 3 if dirty, 4 if dirty/crawling peg, and 5 if fixed. Multinomial logit regression estimates with fixed-effects where the reference category is the fixed regime. The regressions include year dummies. The z-statistics are in parentheses. ⁎⁎ Indicates the statistical significance at the 5% level. ⁎ Indicates the statistical significance at the 10% level.

45

46

Table 2 Multinomial logistic regression estimates: developing countries. Model

Dependent variable: idx3 I

Dependent variable: idx5

II

III

IV

V

VI

2

1

2

1

2

2

3

4

2

3

4

2

3

4

− 1.070** (− 4.816) 0.609** (3.776) –

− 1.076** (− 4.757) –

− 0.900** (− 4.102) –

− 1.109** (− 5.009) –

− 0.969** (− 4.525) –

− 1.120** (− 5.036) –

− 2.063** (− 6.409) –

− 1.494** (− 5.955) –

–

–

− 1.517** (− 5.817) 0.561** (3.024) –

− 1.401** (− 5.455) –

–

–

0.356** (2.424) 0.062** (4.558) 0.404 (1.064) 0.218 (1.307) − 0.604** (− 1.976) − 0.002 (− 0.828) − 0.001 (0.660) − 0.001 (− 0.578) − 1376.682 90.420 0.032

0.301** (2.047) 0.023 (1.604) 0.482 (1.254) − 0.164 (− 0.912) 0.071 (0.230) 0.001 (0.074) 0.001* (1.647) − 0.001 (− 0.965)

0.705** (4.482) 0.061** (4.319) 0.488 (1.241) 0.200 (1.167) − 0.567* (− 1.796) − 0.009** (− 3.172) 0.001 (0.812) − 0.001 (− 0.550) − 1321.551 96.760 0.035

0.469** (3.124) 0.030** (2.103) 0.279 (0.707) − 0.118 (− 0.654) − 0.027 (− 0.087) − 0.003 (− 1.164) 0.001* (1.849) − 0.001 (− 0.917)

0.044** (2.369) 0.472** (3.272) 0.033** (2.371) 0.341 (0.885) − 0.139 (− 0.785) − 0.108 (− 0.356) − 0.002 (− 0.839) 0.001* (1.875) − 0.001 (− 0.914)

–

Democracy

0.058** (3.042) 0.748** (4.931) 0.065** (4.702) 0.432 (1.121) 0.243 (1.452) − 0.494 (− 1.599) − 0.009** (− 3.352) 0.001 (0.754) − 0.001 (− 0.500) − 1389.357 109.720 0.038

0.041* (1.943) –

–

–

0.047** (2.348) –

–

–

0.056** (2.942) –

–

Ideology3

0.045** (2.394) –

− 2.327** (− 7.008) 0.737** (3.211) –

− 2.036** (− 6.168) –

0.056** (2.942) –

− 1.077** (− 4.853) 0.646** (4.105) –

− 1.086** (− 4.780) –

Ideology2

− 1.082** (− 4.884) 0.659** (4.187) –

0.350** (2.387) 0.064** (4.596) 0.427 (1.123) 0.220 (1.318) − 0.619** (− 2.015) − 0.002 (− 0.895) 0.001 (1.144) − 0.001 (− 1.073) − 1753.289 162.000 0.044

− 0.050 (− 0.227) 0.010 (0.457) 1.117** (1.962) − 0.355 (− 1.224) − 0.421 (− 0.906) 0.003 (1.003) 0.002** (2.113) 0.001 (0.289)

0.470** (2.744) 0.017 (1.005) 0.142 (0.321) − 0.100 (− 0.493) 0.517 (1.409) − 0.001 (− 0.223) − 0.002** (− 2.251) − 0.002 (− 1.389)

0.701** (4.477) 0.061** (4.294) 0.531 (1.348) 0.209 (1.219) − 0.567* (− 1.788) − 0.009** (− 3.224) 0.001 (1.143) − 0.001 (− 1.126) − 1694.305 161.870 0.046

0.145 (0.646) 0.017 (0.777) 0.771 (1.302) − 0.245 (− 0.860) − 0.491 (− 1.052) − 0.001 (− 0.023) 0.002** (2.189) 0.001 (0.233)

0.630** (3.572) 0.024 (1.431) 0.012 (0.026) − 0.076 (− 0.372) 0.419 (1.125) − 0.003 (− 1.202) − 0.001** (− 2.119) − 0.002 (− 1.422)

0.058** (3.048) 0.743** (4.919) 0.064** (4.633) 0.475 (1.233) 0.251 (1.502) − 0.490 (− 1.576) − 0.010** (− 3.398) 0.001 (1.015) − 0.001 (− 1.066) − 1786.192 174.780 0.047

0.047** (2.333) 0.164 (0.761) 0.021 (1.018) 0.727 (1.261) − 0.235 (− 0.851) − 0.581 (− 1.285) 0.001 (0.163) 0.002** (2.085) 0.001 (0.341)

0.040* (1.910) 0.625** (3.680) 0.026 (1.588) 0.146 (0.329) − 0.111 (− 0.549) 0.342 (0.939) − 0.002 (− 0.910) − 0.001** (− 2.119) − 0.002 (− 1.367)

Constant Ideology1

Globalization cbi Election rgdp Financial development Inflation Interest rate Log likelihood LR chi2 Pseudo R2 Notes: Same as Table 1.

A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

1

Table 3 Multinomial logistic regression estimates: developed countries. Model

Dependent variable: idx3 I

Dependent variable: idx5 II

III

IV

V

VI

2

1

2

1

2

2

3

4

2

3

4

2

3

4

− 3.410** (− 4.705) 0.115** (2.394) –

− 2.027** (− 7.348) –

− 2.857** (− 3.624) –

− 1.979** (− 7.244) –

− 3.109** (− 3.752) –

− 2.009** (− 7.308) –

− 4.527** (− 3.633) –

− 3.074** (− 3.032) –

–

–

− 3.111** (− 3.515) 0.170 (0.419) –

− 2.651** (− 2.749) –

–

–

0.199** (7.171) − 0.145** (− 4.305) 0.108 (0.157) 0.114 (0.443) − 0.308 (− 0.331) 0.038** (8.962) − 0.033 (− 1.252) 0.083** (2.105) − 411.749 271.880 0.248

0.222 (0.315) − 0.126** (− 3.326) 0.754 (0.970) − 0.218 (− 0.712) 0.613 (0.602) 0.023** (5.085) − 0.011 (− 0.430) 0.147** (3.382)

0.199** (7.254) − 0.140** (− 4.267) − 0.358 (− 0.512) 0.117 (0.455) − 0.101 (− 0.110) 0.038** (8.790) − 0.027 (− 1.037) 0.071* (1.852) − 404.022 276.820 0.255

− 0.024 (− 0.032) − 0.109** (− 2.922) 0.087 (0.109) − 0.185 (− 0.608) 0.221 (0.213) 0.025** (5.288) − 0.003 (− 0.105) 0.133** (3.141)

0.930** (2.158) 0.176 (0.227) − 0.110** (− 2.940) 0.225 (0.285) − 0.144 (− 0.477) 0.105 (0.102) 0.025** (5.277) 0.002 (0.067) 0.126** (3.036)

–

Democracy

0.473 (1.339) 0.195** (7.147) − 0.145** (− 4.405) − 0.243 (− 0.351) 0.107 (0.418) − 0.266 (− 0.293) 0.038** (8.993) − 0.017 (− 0.687) 0.055 (1.470) − 410.307 289.990 0.261

0.484 (0.961) –

–

–

0.421 (0.987) –

–

–

0.182 (0.619) –

–

Ideology3

0.414 (1.167) –

− 4.965** (− 4.319) 0.120** (2.341) –

− 4.375** (− 3.615) –

0.174 (0.593) –

− 2.057** (− 7.320) 0.157 (0.614) –

− 2.054** (− 7.402) –

Ideology2

− 2.033** (− 7.279) 0.154 (0.604) –

0.202** (7.211) − 0.149** (− 4.407) 0.102 (0.147) 0.122 (0.474) − 0.278 (− 0.297) 0.039** (8.986) − 0.035 (− 1.316) 0.086** (2.154) − 507.944 308.8 0.233

0.576 (0.508) − 0.158* (− 3.330) 1.025 (1.080) − 0.142 (− 0.389) 0.390 (0.302) 0.029** (5.414) − 0.040 (− 1.165) 0.178** (3.559)

− 0.101 (− 0.118) − 0.087* (− 1.692) 0.350 (0.319) − 0.353 (− 0.787) 0.943 (0.683) 0.015** (2.251) 0.022 (0.647) 0.106* (1.901)

0.202** (7.307) − 0.145** (− 4.377) − 0.359 (− 0.509) 0.127 (0.490) − 0.070 (− 0.076) 0.039** (8.837) − 0.029 (− 1.105) 0.074* (1.905) − 500.374 313.160 0.238

0.282 (0.241) − 0.151** (− 3.234) 0.485 (0.504) − 0.163 (− 0.448) 0.276 (0.213) 0.030** (5.505) − 0.033 (− 0.933) 0.163** (3.345)

− 0.245 (− 0.268) − 0.057 (− 1.114) − 0.503 (− 0.444) − 0.215 (− 0.494) 0.145 (0.103) 0.017** (2.580) 0.031 (0.896) 0.096* (1.788)

0.481 (1.357) 0.197** (7.210) − 0.149** (− 4.503) − 0.265 (− 0.381) 0.116 (0.450) − 0.224 (− 0.245) 0.039** (9.040) − 0.019 (− 0.746) 0.057 (1.516) − 508.274 327.290 0.244

0.872* (1.678) 0.382 (0.321) − 0.152** (− 3.244) 0.521 (0.544) − 0.137 (− 0.376) 0.372 (0.289) 0.030** (5.518) − 0.031 (− 0.872) 0.162** (3.289)

1.148* (1.898) 0.079 (0.084) − 0.061 (− 1.213) − 0.167 (− 0.151) − 0.156 (− 0.371) − 0.202 (− 0.143) 0.017** (2.559) 0.038 (1.110) 0.082 (1.538)

Constant Ideology1

Globalization cbi Election rgdp Financial development Inflation Interest rate Log likelihood LR chi2 Pseudo R2

A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

1

Notes: Same as Table 1.

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A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

by Bernhard and Leblang (1999), who argue that policymakers utilize any policy instruments that can increase their probability of reelection. Next, we demonstrate that the effect of globalization on exchange rate regime is less strong, and it appears to lose statistical significance in two specifications. Nevertheless, we display that more globalized countries have a higher probability of implementing a fixed regime and no significant effect on choosing a flexible regime (column I). These results are in line with those of Frieden et al. (2010), who display that countries which are more “open to the world economy” are associated with fixed exchange rate regimes (p. 2). Also, the variable financial development has the expected positive and statistically significant coefficient in all equations, implying that countries with higher financial development are more likely to favor a flexible regime. These results are also in line with those of von Hagen and Zhou (2005), Markiewicz (2006) and Frieden et al. (2010). We find that an increase in the level of economic development decreases the probability of choosing a flexible regime. Although this effect is less strong, our findings are not consistent to those of Markiewicz (2006) and Hossain (2009), who discover that larger economies prefer a flexible exchange rate regime. We demonstrate that countries experiencing higher rates of inflation are less likely to employ a fixed regime and no significant effect on choosing a flexible regime. These results parallel the empirical work of Markiewicz (2006) and Frieden et al. (2010), who display that economies with higher inflation rates are associated with a lower likelihood of a fixed exchange rate regime. 19 Finally, we show that the level of domestic interest rates do not impact the choice of exchange rate regime. Next, we turn to investigate the numerical significance of our findings. The probability of choosing a flexible regime (or intermediate regime) relative to the fixed regime can be explained with the odds ratio. We compute the odds ratio by taking the exponential function of the multinomial logistic regression estimates of each independent variable (exp [X]). Hence, a variable with an odds ratio larger than 1 (smaller than 1) indicates higher likelihood (lower likelihood) of implementing a flexible regime relative to the fixed regime. Alternatively, a variable with an odds ratio of 1 implies no relationship with exchange rate regime selection. For the dependent variable idx3, a left-wing government (ideology1) has a 49% higher probability to implement a flexible regime, compared to a fixed regime (exp [0.399]). This magnitude seems to be smaller for ideology2 and ideology3: left-wing governments have a 5.8% and 5.2% higher likelihood to choose a flexible regime relative to a fixed regime, respectively. Also, a democratic institution has a is 35.9% higher probability to choose a flexible regime relative to a fixed regime than non-democracies (exp [0.307]); central bank independence seems to have the largest magnitude, with 161% higher probability to choose a flexible regime (exp [0.960]); further, a government is 29.4% more likely to implement a flexible regime prior to elections (exp [0.258]). Overall, all our estimated results are robust to the dependent variable de facto exchange rate regime 5-ways classification (columns IV, V and VI). In what follows, we attempt to discover differences, if any, on the choice of exchange rate regime in our sample of developing and developed countries.

4.2. Developed vs. developing countries For a deeper investigation, we proceed to uncover some interesting differences in our sample of developed and developing countries. Tables 2 and 3 display the results for our sample of developing and developed countries, respectively. We begin our analysis with the variable government ideology. For developing countries (Table 2), the results suggest that left-wing governments are more likely to choose a flexible regime and less likely to choose a fixed regime. These results are in line with the full sample. However, for developed countries (Table 3), a left-wing government decreases the probability of choosing a fixed regime and no significant effect in the probability of choosing a flexible regime. We demonstrate that left-wing governments favor a flexible exchange rate regime, particularly in developing countries. Overall, we provide strong evidence that government ideology is an important determinant of the choice of exchange rate regime in different economies. In addition, democratic institutions in developing and developed countries increase the probability of implementing a flexible regime and decrease the probability of a fixed regime. These results are, again, consistent with the full sample. We display support that democratic countries in developed and developing economies declare a flexible exchange rate regime since they are more politically accountable institutions (Broz, 2002), facilitate greater information to the public (Fearon, 1994) and incur higher demands to utilize more expansionary monetary policy (Leblang, 1999). We also discover that electoral motives and central bank independence do not influence the choice of exchange rate regime in our samples of developing and developed countries. Further, we display clear differences on the effect of globalization on the choice of exchange rate regime in developing and developed countries. For developed countries, more globalized economies have a higher likelihood of choosing a fixed regime and lower likelihood of choosing a flexible regime. This effect is statistically significant in most equations, providing strong evidence that more globalized economies in developed countries favor a fixed exchange rate regime to lower the risks associated with exchange rate variability that may impede international trade and investment. These results are also in line with the full sample. Alternatively, we discover that more globalized economies in developing countries are more likely to choose a flexible regime and less likely to choose a fixed regime.

19 Nevertheless, high inflation rates significantly challenge the credibility of a fixed regime, which, in turn, suggest that moving to a flexible regime may not be a political decision. Further, it is possible that economies experience low rates of inflation as a result of a fixed regime. We are grateful to one anonymous referee who suggested this possibility.

A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

49

Overall, our model demonstrates interesting implications on the effect of globalization: developed economies prefer a fixed exchange rate regime, whereas developing economies favor a flexible exchange rate regime in the presence of higher levels of global integration. More recently, developing economies experienced a considerable increase in capital flows and trade openness, and hence are extremely involved with their competitiveness in international markets (Goldberg and Pavcnik, 2007). As a result, developing countries may adopt a flexible regime as opposed to “tie their hands” as a fixed regime in order to enable speedy change of the exchange rates and to circumvent lengthy misalignments (von Hagen and Zhou, 2007). In addition, a flexible regime permits the government to regulate the nominal exchange rate to assure the competitiveness in the tradable sector (Broz and Frieden, 2001). For instance, Frieden (2008) and Frieden et al. (2010) emphasize that the tradable producers favor a flexible regime to permit exchange rate policy to influence the competiveness in the tradable sector. Levy-Yeyati and Sturzenegger (2001) also display that flexible regimes are significantly associated with greater economic growth in developing countries. 20 For developed countries, the primary advantage of a fixed regime is to reduce the volatility of the exchange rate and transaction costs (Broz and Frieden, 2001). According to Frieden (2008), the exchange rate regime is also critically important for developed economies, as member countries of the European Union have endeavored “to stabilize their currencies” against each other for over thirty years (p. 354). Further, foreign investors disapprove the uncertainty connected with major instabilities in currency (Frieden et al., 2010). As a result, the more open countries have a greater likelihood of implementing a fixed regime (Frieden, 2008). In addition, higher levels of financial development in developed countries increase the likelihood of a flexible regime and decrease the likelihood of a fixed regime. These findings are also in line with the full sample. However, developing economies with higher financial development are more likely to choose a fixed regime. These results are in line with those of Levy-Yeyati et al. (2010), who find that greater financial integration among non-industrial economies increase the probability of choosing a fixed exchange rate regime. This is anticipated, since financial integration in developing countries is highly correlated with denominated debt and greater currency mismatches (Eichengreen and Hausmann, 2005; Levy-Yeyati et al., 2010). We also discover that an increase in the level of economic development decreases the likelihood of implementing a flexible regime in developing countries. This effect is not statistically significant for developed countries. Further, developing countries that experience higher rates of inflation are less likely to employ a fixed regime and no significant effect on choose a flexible regime. These results are, once more, consistent with the full sample. For developed countries, this effect is not statistically significant. Finally, we show that developed economies with higher level of domestic interest rates are more likely to choose a flexible regime and less likely to choose a fixed regime. However, domestic interest rates do not impact the choice of exchange rate regime in developing countries. This is also consistent with the full sample. As before, we examine the numerical significance of our results in the sub-sample analysis. For developing countries, the coefficient of ideology1 shows that a left-wing government has 93% higher probability to implement a flexible regime relative to a fixed regime, (exp [0.659]), whereas this effect is not significant for developed countries. Democratic institutions in developing and developed countries have a 43% and 22% higher probability to choose a flexible regime than non-democracies, respectively. Our model demonstrates interesting implications on the effect of globalization: developed economies have a 13.50% lower probability to choose a flexible regime, whereas developing economies have a 6.40% higher probability to choose a flexible regime. To sum, we find considerable differences on the type of exchange rate regime a country implements between developing and developed economies. Overall, most of our estimated results for developing and developed countries are robust to the dependent variable de facto exchange rate regime 5-ways classification (Tables 2 and 3 columns IV, V and VI). We also estimate ordered probit model to further support the robustness of our results. The results from the ordered probit estimation are displayed in Tables 4 and 5. Notice that all our variables of ideology are negative and statistically significant for the full sample (columns I, II and III) and developing countries (columns IV, V and VI), suggesting that left-wing governments have a higher probability of implementing a flexible regime. This effect is in line with the dependent variable idx3 and idx5. Alternatively, for developed countries (columns VII, VIII, and IX), this effect is less strong for the dependent variable idx3 and statistically insignificant for the dependent variable idx5. The numerical relevance suggests that a 1 standard deviation increase in the variable ideology1 increases the probability of choosing a flexible regime by about 3.59 percentage points in the full sample (0.178* 0.202), 15.5 percentage points in the developing countries (0.474* 0.326) and 9.19 percentage points in the developed countries (0.489* 0.188). Again, these findings further support that left-wing governments are more likely to choose a flexible regime, especially in developing economies. The remaining results from the ordered probit model are mostly in line with our multinomial logit regression estimates.

5. Conclusion The present paper examines the effect of government ideology, political institutions and globalization on the choice of exchange rate regime. In the case of the full sample, we demonstrate that government ideology, political institutions and globalization are important determinants of the choice of exchange rate regime. In particular, we provide evidence that a left-wing government is more likely to implement a flexible regime and less likely to implement a fixed regime. Further, we show that

20 However, global integration together with a switch from a fixed to a flexible regime in many developing countries creates larger exchange rate variability, which, in turn, may impact income inequality, as documented by Goldberg and Pavcnik (2007).

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A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

Table 4 Robustness checks: ordered probit regression estimates: dependent variable is idx3. Model

I

II

III

IV

–

–

− 0.038⁎ (− 1.934) –

–

− 0.326⁎⁎ (− 4.455) –

Full sample Ideology1 Ideology2 Ideology3

− 0.202⁎⁎ (− 3.435) – –

− 0.036⁎⁎

Election

− 0.143⁎⁎ (− 2.281) − 0.001 (− 0.057) − 0.490⁎⁎ (− 3.476) − 0.130⁎⁎

− 0.223⁎⁎ (− 3.450) − 0.001 (− 0.167) − 0.556⁎⁎ (− 3.815) − 0.143⁎⁎

rgdp

(− 2.003) 0.233⁎

(− 2.169) 0.216 (1.602) − 0.002⁎⁎ (− 2.567) − 0.001 (− 0.385) 0.001 (0.526) − 1904.561 77.360 0.020

(− 2.331) 0.232⁎ (1.766) − 0.002⁎⁎ (− 3.050) − 0.001 (− 0.309) 0.001 (0.524) − 1987.047 87.930 0.022

Globalization cbi

Financial development Inflation Interest rate Log likelihood LR chi2 Pseudo R2

(1.767) − 0.002⁎⁎ (− 3.207) − 0.001 (− 0.100) 0.001 (0.670) − 1970.090 64.390 0.016

VI

VII

–

– –

–

− 0.021⁎⁎ (3.428) –

− 0.188⁎ (− 1.646) –

− 0.175⁎⁎ (− 2.565) − 0.029⁎⁎

− 0.329⁎⁎ (− 4.640) − 0.028⁎⁎

(− 5.106) − 0.030⁎⁎

(− 4.526) − 0.217 (− 1.236) − 0.096 (− 1.196) 0.274⁎

(− 4.358) − 0.259 (− 1.426) − 0.082 (− 0.999) 0.272⁎

(− 4.769) − 0.235 (− 1.326) − 0.100 (− 1.248) 0.248⁎

(1.881) 0.001 (0.545) − 0.001 (− 0.166) 0.001 (0.131) − 1385.102 73.580 0.026

(1.829) 0.003⁎⁎ (2.920) − 0.001 (− 0.560) − 0.001 (− 0.049) − 1329.583 80.700 0.030

(1.713) 0.003⁎⁎ (2.992) − 0.001 (− 0.555) − 0.001 (− 0.090) − 1397.985 92.460 0.032

Developing countries

(− 2.022) − 0.245⁎⁎ (− 3.944) − 0.001 (− 0.139) − 0.546⁎⁎ (− 3.821) − 0.151⁎⁎

Democracy

V

VIII

IX

Developed countries

− 0.021⁎⁎ (3.523) − 0.348⁎⁎

–

– –

–

− 0.139 (− 1.024) –

− 0.719⁎⁎ (− 2.009) 0.076⁎⁎

− 0.618 (− 1.573) 0.071⁎⁎

(5.130) − 0.520⁎ (−1.734) − 0.069 (− 0.579) − 0.199 (− 0.480) − 0.015⁎⁎ (− 9.360) 0.003 (0.275) − 0.035⁎⁎

(4.904) − 0.299 (− 0.976) − 0.060 (− 0.501) − 0.227 (− 0.552) − 0.015⁎⁎ (− 9.178) 0.001 (0.028) − 0.031⁎⁎

(−2.267) − 457.225 180.930 0.165

(− 2.004) − 451.026 182.810 0.169

(− 1.648) 0.072⁎⁎ (4.964) − 0.319 (− 1.055) − 0.067 (− 0.569) − 0.121 (− 0.296) − 0.015⁎⁎ (− 9.485) − 0.004 (− 0.357) − 0.024 (− 1.601) − 456.538 197.530 0.178

VIII

IX

− 0.310⁎ (− 1.877) − 0.667⁎

Notes: The z-statistics are in parentheses. **and* indicates the statistical significance at the 5% and 10% level, respectively. ⁎⁎ Indicates the statistical significance at the 5% level. ⁎ Indicates the statistical significance at the 10% level.

Table 5 Robustness checks: ordered probit regression estimates: dependent variable is idx5. Model

I

II

III

Full sample Ideology1

− 0.175⁎⁎ (− 3.123) –

–

–

Ideology3

–

Democracy

− 0.107⁎ (− 1.786) − 0.004 (− 0.795) − 0.370⁎⁎

− 0.173⁎⁎ (− 2.793) − 0.005 (− 0.922) − 0.414⁎⁎

− 0.037⁎⁎ (− 2.216) − 0.183⁎⁎ (− 3.089) − 0.004 (− 0.848) − 0.407⁎⁎

(− 2.740) − 0.124⁎⁎ (− 2.003) 0.170 (1.353) − 0.002⁎⁎ (− 2.461) − 0.001 (− 0.339) 0.001 (0.285) − 2515.696 46.650 0.009

(− 2.967) − 0.135⁎⁎ (− 2.150) 0.151 (1.174) − 0.001⁎⁎ (− 2.050) − 0.001 (− 0.603) 0.001 (0.154) − 2438.625 60.010 0.012

(− 2.974) − 0.154⁎⁎ (− 2.510) 0.163 (1.298) − 0.002⁎⁎ (− 2.485) − 0.001 (− 0.476) 0.001 (0.167) − 2546.694 67.020 0.013

Globalization cbi Election rgdp Financial development Inflation Interest rate Log likelihood LR chi2 Pseudo R2

V

VI

Developing countries

− 0.040⁎⁎ (− 2.112) –

Ideology2

IV

Notes: The z-statistics are in parentheses. ⁎⁎ Indicates the statistical significance at the 5% level. ⁎ Indicates the statistical significance at the 10% level.

–

− 0.312⁎⁎ (− 4.518) –

Developed countries

–

–

− 0.017⁎⁎

–

–

(− 3.113) –

− 0.125⁎ (− 1.918) − 0.028⁎⁎ (− 4.739) − 0.122 (− 0.728) − 0.044 (− 0.582) 0.144 (1.043) 0.001 (0.958) − 0.001 (− 0.499) − 0.001 (− 0.131) − 1798.412 71.760 0.020

− 0.246⁎⁎ (− 3.648) − 0.028⁎⁎ (− 4.545) − 0.148 (− 0.857) − 0.051 (− 0.662) 0.156 (1.109) 0.003⁎⁎ (2.976) − 0.001 (− 0.871) − 0.001 (− 0.281) − 1742.021 66.440 0.019

VII

− 0.018⁎⁎ (− 3.160) − 0.255⁎⁎ (− 3.936) − 0.030⁎⁎ (− 4.939) − 0.121 (− 0.714) − 0.073 (− 0.970) 0.138 (1.007) 0.003⁎⁎ (3.001) − 0.001 (− 0.813) − 0.001 (− 0.312) − 1835.809 75.550 0.020

− 0.124 (− 1.161) – – 0.288 (1.180) 0.062⁎⁎ (4.595) − 0.580⁎⁎ (− 2.119) − 0.108 (− 0.991) − 0.306 (− 0.802) − 0.011⁎⁎ (− 7.926) 0.002 (0.200) − 0.029⁎⁎ (− 1.994) − 607.231 110.230 0.083

–

–

− 0.081 (− 0.640) –

–

0.527⁎ (1.935) 0.056⁎⁎ (4.169) − 0.304 (− 1.088) − 0.095 (− 0.865) − 0.235 (− 0.607) − 0.011⁎⁎ (− 7.960) − 0.001 (− 0.061) − 0.024 (− 1.635) − 594.961 123.990 0.094

− 0.200 (− 1.323) 0.550⁎⁎ (1.981) 0.056⁎⁎ (4.176) −0.290 (− 1.052) − 0.097 (− 0.900) − 0.131 (− 0.343) − 0.011⁎⁎ (− 8.278) − 0.004 (− 0.397) − 0.018 (− 1.281) − 603.985 135.870 0.101

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democratic institutions, election motives, central bank independence and greater financial development increase the likelihood of choosing a flexible regime. We also display that more globalized countries have a higher probability of choosing a fixed regime and economies with higher rates of inflation are less likely to implement a fixed regime. Finally, countries that experience higher level of economic development are less likely to choose a flexible regime. Next, we uncover several differences on the choice of exchange rate regime in our sample of developing and developed countries. For example, we show that a left-wing government in a developing economy is more likely to choose a flexible regime. For developed countries, a left-wing government decreases the probability of choosing a fixed regime and no significant effect of choosing a flexible regime. Also, our findings suggest that more globalized countries in developed economies favor a fixed regime, whereas developing economies prefer a flexible regime. Further, greater financial development in developed countries increases the probability of a flexible regime, though developing countries are more likely to choose a fixed regime. We also show that economic development decreases the probability of a flexible regime in developing countries. In addition, higher rates of inflation in developing countries decrease the likelihood of a fixed regime. In contrast, the level of economic development and inflation rate does not impact the choice of exchange rate regime in developed countries. Finally, we discover that higher level of domestic interest rates in developed countries is more likely to choose a flexible regime. This effect is not, however, statistically significant for developing countries. More importantly, our estimated results are robust to the dependent variable de facto exchange rate regime 5-ways classification, and the results from the robustness estimation provide strong evidence that our findings are robust in accordance with our baseline specification. To sum, we find that government ideology, political institutions and globalization are fundamental determinants of the type of exchange rate regime a country implements. More importantly, we highlight that political economy factors have different effects on the choice of exchange rate regime in developed and developing countries. It is therefore critically important to account for the political economy variables in exchange rate policy decisions. In addition, we emphasize the significance of examining the developed and developing country samples in order to devise adequate exchange rate policies, as we propose these implications for further research. Acknowledgements We thank the editor and two anonymous referees for their helpful comments and suggestions. An earlier version of this paper was completed while Chun-Ping Chang was a visiting scholar at the University of Kentucky. Chun-Ping Chang is grateful to the National Science Council of Taiwan for financial support through grant NSC 99-2410-H-158-001. All remaining errors are our own. Appendix A

Table A1 Data definitions, sources and descriptive statistics. Variable

Definition

Source

idx3

De facto exchange rate 3-ways classification: (1 = float; 2 = intermediate; 3 = fixed). De facto exchange rate 5-ways classification (1 = inconclusive; 2 = float; 3 = dirty; 4 = dirty/crawling peg; 5 = fixed) Dummy variable coded 1 if the government is a left-wing party

Levy-Yeyati and Sturzenegger (2005) Levy-Yeyati and Sturzenegger (2005)

idx5

Ideology1 Ideology2 Ideology3

The ideology of government party (-1: right; 0: central; 1: left) weighted by the share of seats in parliament The 5-years moving average data of ideology2

Democracy Globalization cbi Election

1 if the regime is democratic, 0 otherwise Overall globalization index Central bank independence index The election date of 1-year lag

rgdp

Real GDP (constant in 2000, natural logarithms)

Financial Domestic credit to private sector(% of GDP) development Inflation Inflation, consumer prices (annual %) Interest rate

Lending interest rate (%)

Democracy Cross-national Data: Pippa Norris Database of Political Institution (2010) Database of Political Institution (2010) Cheibub et al. (2010) 2011 KOF Globalization Index Klomp and De Haan (2009) International Institute for Democracy and Electoral Assistance World Development Indicator (2009) World Development Indicator (2009) World Development Indicator (2009) World Development Indicator (2009)

Mean

Standard Observations deviation

2.4509

0.7943

4222

4.1404

1.2547

4287

0.3535

0.1781

3875

0.1226

0.4931

3847

0.1153

0.4514

4371

0.4497 0.1975 43.8481 16.9385 0.4836 0.2118 0.1521 0.0591

5003 5138 4557 5580

22.9759

2.3987

4758

39.0071 34.9796

4411

23.1465

7.2340

4189

18.4024

6.8615

3421

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Table A2 List of countries. Developed countries Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Luxembourg Mexico Netherlands New Zealand Norway Portugal South Korea Spain Sweden Switzerland Turkey United Kingdom United States

Developing countries Afghanistan Albania Algeria Angola Antigua and Barbuda Argentina

Armenia Aruba Azerbaijan Bahamas, The Bahrain Bangladesh Barbados Belarus Belize Benin Bhutan Bolivia Bosnia and Herzegovina Botswana Brazil Brunei Darussalam Bulgaria Burkina Faso Burundi Cambodia Cameroon Cape Verde Central African Republic Colombia Comoros Congo, Dem. Rep. Congo, Rep. Costa Rica Cote d'Ivoire Croatia Chad Chile China Cyprus Czech Republic Djibouti Dominica

Dominican Republic Ecuador Egypt, Arab Rep. El Salvador Equatorial Guinea Estonia Ethiopia Fiji Gabon Gambia, The Georgia Ghana Grenada Guatemala Guinea Guinea-Bissau Guyana Haiti Honduras Hong Kong, China Hungary India Indonesia Iran, Islamic Rep. Iraq Israel Jamaica Jordan Kazakhstan Kenya Kiribati Kuwait Kyrgyz Republic Lao PDR Latvia Lebanon Lesotho

Liberia Libya Lithuania Macedonia, FYR Madagascar Malawi Malaysia Maldives Mali Marshall Islands Mauritania Mauritius Micronesia, Fed. Sts. Moldova Mongolia Morocco Mozambique Myanmar Namibia Nepal Netherlands Antilles Nicaragua Niger Nigeria Oman Pakistan Palau Panama Papua New Guinea Paraguay Peru Philippines Poland Qatar Romania Russian Federation Rwanda

St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines Samoa San Marino Sao Tome and Principe Saudi Arabia Senegal Seychelles Sierra Leone Singapore Slovak Republic Slovenia Solomon Islands Somalia South Africa Sri Lanka Sudan Suriname Swaziland Syrian Arab Republic Tajikistan Tanzania Thailand Togo Tonga Trinidad and Tobago Tunisia Uganda Ukraine United Arab Emirates Uruguay Venezuela, RB Vietnam Yemen, Rep. Zambia Zimbabwe

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