Capital market development, corporate governance and the credibility of exchange rate pegs

Olli Castrén () and Tuomas Takalo
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Olli Castrén: European Central Bank, Kaiserstrasse 29, Postfach 16 03 19, 60066 Frankfurt am Main, Germany., http://www.ecb.europa.eu/home/html/index.en.html

No 34, Working Paper Series from European Central Bank

Abstract: Focusing on emerging market currency arrangements, we build a model of an exchange rate peg with escape clauses and output persistence. We first show how output persistence works as anadditional “fundamental” so that an exogenous increase in persistence can make the currency peg more vulnerable to speculative attacks. We then endogenise output persistence as arising from capital market frictions that are caused by weak corporate governance institutions. It turns out that in emerging market economies, often characterised by credit constraints, a partial reform of corporate governance institutions may enhance a financial accelerator mechanism, which increasesoutput persistence and deteriorates the credibility of the exchange rate peg. A conservative policymaker partially counters this adverse effect, but only a complete reform of corporate governance institutions fully eliminates persistence and reduces the risk of currency crisis on all levels of policy preferences. Therefore, to avoid harmful long-run output distortions high emphasis should be assigned on reforming the economy’s both economic and legal institutions prior to fixing the exchange rate. JEL Classification: E58; F33; D84; G18; G38.

Keywords: Exchange rate pegs; speculative attacks; output persistence; capital market frictions; corporate governance. (search for similar items in EconPapers)
Date: Written
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