Exchange Rate Policy and Debt Crises in Emerging Economies

IMF Working Papers, March 1, 2003

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Exchange Rate Policy and Debt Crises in Emerging Economies

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Bibliographic details

• Authors: Peter J Montiel, Samir Jahjah
• Published: March 1, 2003
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451848076.001

Summary findings

• The model captures interaction between exchange rate policy, fiscal policy, and outright default on foreign-currency denominated debt.
• Under a credible hard peg (currency board), default is a more likely outcome even without an exceptionally large short-term debt, because devaluation is not an option.
• Under a conventional fixed peg, the government may optimally choose an exchange rate level that is likely to result in partial or complete debt default.
• Depending on the exchange rate regime, multiple equilibria can exist; one equilibrium features:
  • high interest rate,
  • overvalued exchange rate,
  • low output,
  • high default.
• Under a hard peg, there is a unique equilibrium.

Model mechanisms and channels

• The exchange rate affects the supply of short-term debt facing the government.
• Credible hard peg removes devaluation as a policy option, altering default incentives.
• Fixed peg regimes allow the government discretion over the exchange rate level, potentially inducing policies that increase default likelihood.

Scenarios and equilibria

• Multiple equilibria under certain exchange rate regimes:
  • Equilibrium A (adverse): high interest rate; exchange rate overvaluation; low output; high default.
  • Equilibrium B (more favorable): not described in detail in the summary, but implied to contrast with Equilibrium A.
• Unique equilibrium under a credible hard peg characterized by the absence of multiple self-fulfilling outcomes.

Policy implications

• Exchange rate regime choice materially affects government default risk on foreign-currency debt.
• Hard pegs (currency boards) can increase default probability by eliminating devaluation as an adjustment mechanism.
• Under fixed pegs, governments may set exchange rates that trade off exchange rate stability against higher default risk; policymakers should consider this trade-off when designing exchange rate and fiscal policies.

Content in this bundle

• Exchange Rate Policy and Debt Crises in Emerging Economies - WP/03/60, corrected
  • Exchange Rate Policy and Debt Crises in Emerging Economies - WP/03/60, corrected (Markdown version)
  • Exchange Rate Policy and Debt Crises in Emerging Economies - WP/03/60, corrected (PDF)