Exchange Rate Policy and Sovereign Spreads inEmerging Market Economies

Inci Gumus�

Sabanci University

January 2011

AbstractThe exchange rate policy of a country is closely related to the current and future

macroeconomic performance of the economy. Therefore, it is expected that the riskperceptions about a country would be a¤ected by its exchange rate policy. This pa-per empirically analyzes the relationship between exchange rate policy and sovereignrisk premia in emerging market economies, considering both the actual exchange ratebehavior and the o¢ cially declared regimes. The results show that countries that an-nounce a �xed exchange rate regime face lower spreads than countries that announcea �oating regime or intermediate �exibility. When the actual exchange rate behavioris considered, this relationship persists between intermediate �exibility and pegs butcountries that allow their exchange rates to freely �oat do not face higher spreads inthis case. The di¤erence between the results is due to the fact that many countriesdeviate from their declared exchange rate policy. The empirical analysis also revealsthat the countries that announce a �oating regime do not face higher spreads thanpegs when they actually allow a high degree of �exibility as they announced. How-ever, intermediate �exibility leads to higher spreads independently of whether this isthe announced policy or the actual behavior.

JEL Classi�cation: E58, F31, F34Keywords: Sovereign spreads; Exchange rate regimes; Default risk

�I would like to thank Carlos Vegh, Firat Inceoglu, Seda Ertac, the participants at the 8th INFINITIConference on International Finance and two anonymous referees for helpful comments and suggestions.Financial support from the Scienti�c and Technological Research Council of Turkey (TUBITAK 1001) isgratefully acknowledged. All errors are my own. Correspondence: Sabanci University, Faculty of Arts andSocial Sciences, Orhanli-Tuzla, 34956, Istanbul, Turkey. Tel: +90-216-4839318; Fax: +90-216-4839250;Email: incigumus@sabanciuniv.edu.

1 Introduction

Emerging market economies face substantially higher interest rates in international �nancial

markets compared to developed economies. The premium on interest rates that is due to

sovereign default risk re�ects the risk perceptions about an economy, and is a¤ected by both

the general macroeconomic state of the economy and global economic conditions. Being

one of the main macroeconomic policy choices, the exchange rate policy is closely linked to

the macroeconomic performance of an economy as well as how the economy is a¤ected by

changes in international markets. Therefore, the debt repayment capacity of a country and

the risk perceptions of international investors are expected to be a¤ected by the exchange

rate regime that the country follows. This paper aims to empirically analyze the e¤ect of

exchange rate policy on sovereign default risk premia in emerging market economies.

The exchange rate regime pursued by a country can a¤ect the default risk through dif-

ferent channels. By determining the monetary policy options available to an economy, it

acts as an important factor in a¤ecting the macroeconomic performance of the economy. In

this sense the announced exchange rate regime of a country is important in conveying infor-

mation about how monetary policy will be conducted, and therefore may a¤ect the private

sector�s and investors�expectations even before its e¤ects have been realized. Speci�cally,

it has been argued that a �xed exchange rate regime has a disciplining e¤ect on the policy

makers since it constrains the discretion of the monetary authority. Fixed exchange rates,

therefore, render credibility to the economy and they are perceived as a commitment to

maintaining macroeconomic stability.1 If this argument is valid, the disciplining e¤ect of

a peg would lead to a reduction in the sovereign risk premium since the macroeconomic

fundamentals are expected to improve, which in turn reduces debt repayment problems

and the likelihood of default.

On the other hand with a �exible exchange rate regime, monetary policy can be used

1For arguments about the disciplining role of �xed exchange rates see Eichengreen and Rose (1998),Mishkin and Savastano (2001) and Ghosh, Gulde and Wolf (2002).

1

to mitigate the e¤ects of shocks that an economy is exposed to. In this case, the country

can set its monetary policy independently, and if it is expected to be used e¤ectively, this

freedom would be rewarded by lower spreads on international borrowing.

Besides serving as a signal for private sector�s expectations about macroeconomic per-

formance, the exchange rate policy directly a¤ects many aspects of an economy. It is a

well-documented fact that most of the developing country borrowing in international mar-

kets is denominated in foreign currency. Therefore, exchange rate �uctuations have a direct

e¤ect on the debt burden of these countries, substantially a¤ecting their repayment ability.

The changes in the exchange rate also a¤ect the trade competitiveness of the economy and

the availability of funds through exports. This in turn has an e¤ect on the short-term

liquidity and the default risk of the country. Movements in the exchange rate also a¤ect

the �nancial stability of emerging markets, as the exchange rate pass-through to in�ation is

quite high and large depreciations are associated with current account adjustments and out-

put declines.2 The default risk assessments of these countries are therefore closely related

to the exchange rate policy. Reinhart (2002) shows that the majority of emerging mar-

ket defaults is associated with currency crises. Analyzing the behavior of sovereign credit

ratings, she concludes that currency crises increase the likelihood of default in emerging

markets. It is also true that recent �nancial crises have mostly erupted in countries that

had �xed exchange rate regimes, which may have created a bias against pegs in terms risk

perceptions.

In this paper I empirically analyze the relationship between exchange rate policy and

sovereign default risk premia in emerging market economies. The exchange rate regimes

o¢ cially declared by monetary authorities are compiled by the IMF and form a de jure

exchange rate classi�cation. However, as has been documented in the literature on exchange

rates, the actual exchange rate policy may substantially di¤er from the announced regime.3

2See Calvo and Reinhart (2001 and 2002).3See Calvo and Reinhart (2002), Ghosh, Gulde and Wolf (2002), Reinhart and Rogo¤ (2004), Levy-

Yeyati and Sturzenegger (2005).

2

The de jure exchange rate classi�cation, therefore, may fail to capture the e¤ect of the

exchange rate policy on default risk if the monetary authority does not commit to the

announced exchange rate regime. In this sense, using a de facto exchange rate classi�cation,

which is based on the observed behavior of the exchange rates, may be better in analyzing

the relationship between the actual exchange rate policy and sovereign risk. This analysis

would also reveal the di¤erences, if any, between the e¤ects of the declared exchange rate

regime and the actual exchange rate policy on risk premia. Therefore, the empirical analysis

is carried out using both de jure and de facto classi�cations of exchange rate regimes,

in order to disentangle the di¤erences in the way sovereign spreads are a¤ected by each

classi�cation. Since many countries deviate from their announced policies, there can be a

di¤erence in terms sovereign spreads between those that commit to their announced policies

and those that act di¤erently. In order to reveal these di¤erences, the e¤ects of deviating

from the announced exchange rate policy are also analyzed.

The results of the empirical analysis suggest a quite di¤erent e¤ect for the two exchange

rate classi�cations. Countries that announce a �oating regime or a regime with an inter-

mediate level of �exibility face higher sovereign spreads than those that announce a �xed

exchange rate regime, controlling for other factors that may a¤ect default risk. With a de

facto classi�cation on the other hand, the results illustrate that countries that allow their

exchange rates to �oat freely do not pay higher spreads than countries that follow a peg.

However, in this case intermediate �exibility still leads to higher spreads compared to �xed

exchange rates. Therefore, when the actual exchange rate behavior is considered, coun-

tries that go to either one of the two extremes are rewarded with lower sovereign spreads

compared to countries that allow a limited �exibility.

In terms of the announced policies, the results of the analysis support the idea about

the credibility-enhancing role of �xed exchange rate regimes since declaring that a �xed

exchange rate regime will be followed leads to lower borrowing costs compared to other

regimes. Since the actual exchange rate behavior can be quite di¤erent from the announced

3

regime, this only gives information about the e¤ect of announcing a certain regime without

considering whether this regime is actually followed. As documented by Calvo and Reinhart

(2002), many countries that announce a �oating regime actually deviate from this and

limit the exchange rate �uctuations. The regression results that analyze the e¤ects of

this kind of behavior show that among the countries that announce a �oating regime,

those that actually follow this announcement pay similar spreads as the countries that

announce a �xed exchange rate regime. Therefore, when the countries that display a "fear

of �oating" behavior are excluded, announcing a �oating exchange rate does not lead to

higher borrowing costs. However, announcing an intermediate level of �exibility leads to

higher spreads even when the group of countries that deviate from this policy are excluded.

Therefore, in the case of intermediate �exibility, higher spreads are not related to whether

the announced policy is actually being followed, whereas for countries classi�ed as having

a �oating exchange rate regime, there is no increase in borrowing costs if the announced

policy is followed.

The determinants of sovereign default risk in developing countries have been the subject

of an extensive literature.4 However, only a few studies have focused on the relationship

between exchange rate regime choice and sovereign risk premia. The papers by Bordo and

Rocko¤ (1996) and Obstfeld and Taylor (2003) study sovereign spreads during the gold

standard. These papers show that in the pre-World War I era, the countries that more

strictly adhered to the gold standard were charged lower interest rates. This e¤ect, however,

seems to be absent in the interwar period according to Obstfeld and Taylor (2003) meaning

that the gold standard was less credible in this period.

Jahjah and Yue (2004) and Barajas et al. (2008) analyze the e¤ects of exchange rate

policy on sovereign bond spreads in a more recent context. In order to capture the exchange

rate policy, Jahjah and Yue (2004) use de facto exchange rate classi�cations and real

4See Edwards (1984), Rockerbie (1993), Cline and Barnes (1997), Kamin and von Kleist (1999), Eichen-green and Mody (2000), Ferrucci (2003), Gonzalez-Rozada and Levy-Yeyati (2008).

4

exchange rate misalignment. Barajas et al. (2008), on the other hand, use a de jure

exchange rate classi�cation and they also examine the e¤ects of exchange rate intervention

on spreads using an intervention index that they construct. In this paper, I analyze the

relationship between exchange rate policy and sovereign spreads using both the announced

exchange rate regimes and the actual exchange rate policies. As the analysis is conducted

in the same sample, with the same set of explanatory variables for both exchange rate

classi�cations, it provides a direct comparison of the e¤ects of these two classi�cations and

reveals the di¤erences between these e¤ects clearly. I also analyze the e¤ects of deviating

from the announced exchange rate regime on sovereign risk premia. As it is a widely

documented fact that many developing countries do not follow the exchange rate policies

that they announce, it is important to analyze the e¤ects of this behavior on sovereign

spreads.

In their analysis, Jahjah and Yue (2004) conclude that an overvalued real exchange rate

increases bond spreads and this e¤ect becomes more prominent for a �xed exchange rate

regime. Their results also suggest that an intermediate level of exchange rate �exibility

leads to lower spreads. This result is at odds with the �ndings of the current paper. This

di¤erence can be explained by di¤erences in the sets of explanatory variables used in the

two papers. Speci�cally, including the ratio of international reserves to GDP among the

explanatory variables a¤ects this result, which is discussed in more detail in section (3.1).

The results of Barajas et al. (2008) indicate that having a �xed exchange rate regime

as the declared policy leads to lower sovereign spreads. They also �nd that exchange rate

intervention reduces spreads in the whole sample but has no signi�cant e¤ect in the sample

of countries that are classi�ed as �oating. Their �nding about de jure �xed exchange rate

regimes leading to lower spreads is consistent with this paper. However, it is found in

this paper that for countries that are classi�ed as having a �oating exchange rate regime,

committing to the announced policy and not intervening reduces sovereign spreads.

The rest of the paper is organized as follows: Section 2 describes the data and provides

5

summary statistics. In section 3 the empirical analysis and the results are presented.

Section 4 concludes.

2 The Data

2.1 Exchange Rate Regime Classi�cations

In the empirical analysis, exchange rate policies are identi�ed with two di¤erent classi�ca-

tions: a de jure classi�cation and a de facto classi�cation. The exchange rate classi�cation

based on the exchange rate regime o¢ cially declared by each country forms the de jure

classi�cation. The o¢ cial exchange rate classi�cation is compiled by the IMF and made

available in the IMF�s Annual Report on Exchange Arrangements and Exchange Restric-

tions (AREAER). The AREAER contains the intended exchange rate policies that member

countries report to the IMF on an annual basis. However, since 1998 the classi�cations have

been adjusted to re�ect the actual exchange rate behavior, and the information available

in AREAER do not correspond to the de jure classi�cation directly. In most cases where

there is a discrepancy between the declared regime and the actual behavior, however, this

has been stated. The de jure classi�cation used in this paper, therefore, has been adjusted

to re�ect this information and diverges from the IMF classi�cation when it has been stated

that the de jure classi�cation is di¤erent.

Many countries deviate from their announced exchange rate regime in conducting ex-

change rate policies. The "fear of �oating" phenomenon introduced by Calvo and Reinhart

(2002) points out to the fact that there are many countries that declare a �oating exchange

rate regime and exhibit very low exchange rate volatility stemming from deliberate actions

to stabilize the exchange rate. Based on the observation that the actual exchange rate

policies can be quite di¤erent from the o¢ cially declared regimes, di¤erent authors have

developed "de facto" classi�cations, which are based on actual exchange rate behavior.

One such classi�cation is developed by Reinhart and Rogo¤ (2004). A key feature of the

6

Reinhart and Rogo¤ classi�cation is that they use data on parallel and dual exchange rate

markets. They argue that dual rates and parallel markets have been quite prevalent and

that these market-determined rates are better measures of monetary policy. In order to

identify exchange rate regimes, Reinhart and Rogo¤ sort out the observations with par-

allel or dual markets. If there is no dual rate or parallel market, they verify the o¢ cial

regime announcement by using summary statistics. In cases without an announcement or

if the announcement fails veri�cation, they decide on the de facto classi�cation by direct

statistical inference, which is also used for country-year observations with dual or parallel

markets. The statistical evaluation method uses the mean absolute monthly change in the

market-determined (o¢ cial or parallel) nominal exchange rate, based on a �ve-year moving

window.

Another de facto classi�cation is developed by Levi-Yeyati and Sturzenegger (2005)

(henceforth LYS). LYS identify a country�s de facto exchange rate regime by considering the

combined behavior of three variables: changes in the nominal exchange rate, the volatility

of these changes, and the volatility of international reserves. The �xed exchange rate

regimes are associated with a high volatility of international reserves aimed at reducing the

volatility of the exchange rate, whereas �exible regimes are characterized by high volatility

of the exchange rate with relatively stable reserves.

Both classi�cations have been widely used in the literature and both have their own

merits. The main classi�cation used in this study is an extended version of the Reinhart and

Rogo¤classi�cation. One reason for using this classi�cation is the fact that they use market

rates while the LYS classi�cation uses o¢ cial exchange rates, and as noted by Reinhart

and Rogo¤, dual rates have been quite common in emerging market economies, which is

the country group that this paper focuses on. Another reason is that this classi�cation

has been extended by Ilzetzki, Reinhart and Rogo¤ (2008) (henceforth IRR) to cover the

period until the end of 2007, whereas the LYS classi�cation is only available through the

end of 2004. Therefore, IRR classi�cation will be used in this study and LYS will be used

7

to check the robustness of the results.

The exchange rate categories given in the two classi�cations are grouped into three main

categories; �xed, intermediate �exibility and �oating; in order to be used in this paper. The

IMF and IRR classi�cations and the details of the exchange rate categories are given in

the Appendix. In order to analyze the e¤ect of exchange rate policy on sovereign spreads,

dummy variables are formed to represent each exchange rate category, where the dummies

take the value of one if a speci�c exchange rate regime prevailed in a given period, and zero

otherwise.

Other than the categories constructed by the exchange rate behavior, IRR has a separate

"freely falling" category for the cases with annual in�ation rate over 40 percent. Since the

in�ation rate is included in the empirical analysis as an explanatory variable, this distinction

does not seem necessary in the current paper. Therefore, the "freely falling" observations

are assigned to one of the three exchange rate categories by using the information given in

the data appendix of IRR and �nding the exchange rate category that would be assigned

to that observation, had it not been classi�ed as �freely falling�.

2.2 Sovereign Spreads and Explanatory Variables

Emerging market sovereign spreads are measured by J.P. Morgan�s Emerging Markets Bond

Index Global (EMBIG). The EMBIG spreads measure the premium above U.S. Treasury

securities in basis points for dollar denominated sovereign debt. The EMBIG sample covers

33 countries for di¤erent time periods, earliest one starting in the �rst quarter of 1998. This

paper uses quarterly observations, which are computed by taking the averages of daily data.

Since quarterly data are missing for some of the explanatory variables, the empirical analysis

covers 21 countries out of the EMBIG sample. The time period runs from 1998 Q1 to 2007

Q4 since the exchange rate classi�cations are only available through the end of 2007.

The explanatory variables used in the empirical analysis are meant to capture the sol-

vency and liquidity of an economy as well as the macroeconomic fundamentals and inter-

8

national economic conditions. The data for the explanatory variables are mainly obtained

from IMF�s International Financial Statistics database and World Bank�s Global Develop-

ment Finance and Quarterly External Debt Statistics databases (detailed information is

given in the Appendix).5 The variables that are used to measure the liquidity and solvency

are external debt-to-GDP, international reserves-to-GDP and current account-to-GDP ra-

tios. Among these, a high ratio of external debt to GDP is expected to increase solvency

problems and is associated with a higher default risk. International reserves can be used

to �nance debt service payments in case of a sudden liquidity problem and therefore, this

variable is expected to be negatively related to sovereign spreads. The current account

de�cit equals the increase in a country�s net liabilities to foreigners. Persistently high cur-

rent account de�cits are usually perceived as a signal for potential liquidity problems and

a balance of payments crisis. Therefore, the ratio of current account balance to GDP is

expected to be negatively related to sovereign default risk.

The growth rate of GDP is included in the regressions as a measure of both the long-

term solvency and the macroeconomic fundamentals of a country. A higher growth rate

signals a greater ability to service debt in the future and sovereign spreads are expected to

be lower with a higher growth rate. The in�ation rate can be considered as a proxy for the

e¤ectiveness of economic management and an increase in the in�ation rate is expected to

be positively related to spreads.

Two measures of openness are used in the regressions. One of them is a measure of

�nancial openness or international �nancial integration, which is measured by the sum

of gross stocks of foreign assets and liabilities as a ratio to GDP, as suggested by Lane

and Milesi-Ferretti (2003).6 The level of international �nancial integration is expected to

5For some series, data from the statistics agencies and the central banks of individual countries havebeen used.

6Both de jure and de facto measures of �nancial openness have been used in the literature. As arguedby Kose et al. (2009), de jure measures, which are based on legal restrictions on cross-border capital �ows,may not accurately re�ect the actual degree of international �nancial integration of an economy. Therefore,a de facto �nancial openness variable is used in this paper.

9

be positively related to economic growth through better access to �nancing for domestic

investment, even though the results on this issue are not clear (Kose et al., 2009). Financial

openness can also be thought to promote development of the domestic �nancial sector and

impose discipline on macroeconomic policies. In this sense, higher �nancial integration

would be expected to lower sovereign spreads. However, �nancial openness also increases

the vulnerability of an economy to sudden reversals of capital �ows and may increase the

probability of �nancial crises. The fact that the e¤ectiveness of monetary policy in a �xed

exchange rate regime depends on �nancial openness also makes this variable important

in the relationship between the exchange rate policy and sovereign risk premia. Trade

openness, de�ned as the sum of exports and imports as a ratio of GDP, is the other measure

of openness used in the empirical analysis. Debt repayment incentives may be lower for an

economy that is relatively closed, since losses from sanctions following debt repudiation are

smaller (Ferrucci, 2003). In this sense trade openness is expected to be negatively related

to sovereign spreads. However, openness may also increase the susceptibility of a country to

foreign shocks such as higher energy prices and exchange rate depreciations, which suggests

a positive relationship between spreads and trade openness (Rockerbie, 1993).

The three-month U.S. Treasury-bill rate is used as a proxy for the international interest

rate to capture the e¤ects of external �nancial developments on the default risk of a country.

An increase in the U.S. interest rates reduces the demand for emerging market bonds

and also increases the borrowing costs of emerging markets. In this sense this variable is

expected to be positively related to spreads. However, if higher cost of borrowing leads to

a decline in the supply of emerging market bonds with a fewer number of emerging-country

issuers coming to the market, then a higher international interest rate may be associated

with lower spreads as well (Eichengreen and Mody, 2000).

These variables are commonly used in papers that analyze the determinants of default

risk. Other commonly used variables such as the ratio of investment to GDP, the ratio

of debt service to exports and the ratio of short-term debt to total external debt are not

10

included in the baseline regression because of missing data for some countries and time

periods. However, these are used in additional regressions in order to check the robustness

of the results.7

2.3 Preliminary Data Analysis

Table 1 shows the percentage of observations in each exchange rate category using both

de jure and de facto classi�cations for the sample that is used in the regression analysis.

In the de jure classi�cation most of the observations are in the �oating category, followed

by the intermediate and the �xed categories. When de facto classi�cation is considered

however, a di¤erent picture emerges. In this case a signi�cant fraction of the observations

are in the intermediate category, followed by the �xed exchange rate category. With this

classi�cation, only a small fraction of observations are classi�ed as �oating.

The pattern observed in Table 1 is very much in line with the "fear of �oating" phe-

nomenon with the percentage of observations in the �oating category falling from 41.9% in

the case of declared regimes to only 9.5% in the case of the de facto classi�cation. Num-

ber of observations in the intermediate category increases substantially with the de facto

classi�cation, suggesting that many countries that declare a �oating exchange rate regime

only allow a limited level of �exibility. In the case of the �xed exchange rate category, the

percentage of observations does not change much between the two classi�cations.

7Government budget balance is another variable that is commonly used in the literature but using thisvariable results in a major reduction in the sample size because of lack of data. Therefore, it is not usedin the regression analysis.

11

Table 1. Summary StatisticsPercentage of Observations Mean Spreads

in Each Category (Basis Points)De jure De facto De jure De facto

Fixed 26.0% 22.4% 496.61 565.91(34.82) (43.66)

Intermediate 32.1% 68.1% 719.53 436.09(90.53) (32.67)

Floating 41.9% 9.5% 415.74 498.46(24.77) (77.12)

Note: Standard errors are in parentheses.

In Table 2 mean spreads for di¤erent exchange rate regimes are illustrated for both

classi�cations. In the case of the de jure classi�cation intermediate exchange rate category

has the highest average spread, whereas for the de facto classi�cation this category has the

lowest average spread. With the de facto classi�cation the highest mean spread is in the

�xed exchange rate category. Therefore, a �rst-pass analysis of the data reveals that the

relationship between exchange rate policy and sovereign spreads can change considerably

depending on the classi�cation used.

3 Empirical Analysis

Following Edwards (1984) and the subsequent literature, it is assumed that the log of

spreads is a linear function of explanatory variables of default risk. Using pooled quarterly

data, the basic �xed-e¤ects regression equation is of the form:

log(spreadit) = �i + �Xit + uit

where i denotes the country and t denotes the time, the dependent variable is the logarithm

of the sovereign spread, Xit is a vector of explanatory variables including the dummy

variables for the exchange rate regimes, �i captures the country �xed e¤ects and uit is a

random error term. The regressors in the baseline regression are the growth rate of GDP,

the in�ation rate, the ratio of current account to GDP, the ratio of international reserves

12

to GDP, the ratio of external debt to GDP, �nancial openness, trade openness, the three-

month U.S. Treasury-bill rate and exchange rate regime dummies �oat and intermediate,

as described in the data section. The coe¢ cients of the dummy variables represent the

relationship between spreads and exchange rate regimes relative to a �xed exchange rate

regime, which is the omitted category. The t-statistics presented are based on a cluster-

robust covariance matrix in order to correct for potential heteroskedasticity and serial

correlation of the error term.

The data used in the regression analysis covers 21 countries for the period 1998 Q1-2007

Q4. The model is estimated for de jure and de facto classi�cations separately.

3.1 Baseline Regression Results

Table 3 shows the results for the �xed-e¤ects regression of the baseline model. The �rst

column in the table shows the regression results without the exchange rate dummies, the

second column is for the de jure classi�cation and the last column is for the de facto

classi�cation.

In all regressions, the reserves-to-GDP ratio and the external debt-to-GDP ratio are

highly signi�cant, and the reserves-to-GDP ratio has the highest coe¢ cient. In�ation rate

and �nancial openness are also highly signi�cant variables, followed by growth rate in terms

of signi�cance. The coe¢ cients of in�ation rate, growth rate, the ratio of reserves to GDP

and the ratio of external debt to GDP have the expected signs. Both �nancial openness

and trade openness variables are negatively related to sovereign spreads, even though trade

opennesss is signi�cant in only one of the regressions. These two variables show that a higher

degree of openness, especially �nancial openness, leads to lower spreads. The coe¢ cient of

current account to GDP has the opposite sign of what economic intuition suggests, however

it is insigni�cant. The positive coe¢ cient of this variable is consistent with other studies on

the determinants of default risk premium (Barajas et al., 2008; Min, 1998; Edwards, 1984).

The U.S. interest rate has a negative coe¢ cient, suggesting a supply side e¤ect as explained

13

in section (2.2), however this e¤ect is also insigni�cant. Other studies on sovereign default

have also found the U.S. interest rate to have a negative e¤ect on sovereign spreads (Jahjah

and Yue, 2004; Eichengreen and Mody, 2000) or to have no statistically signi�cant e¤ect

(Kamin and von Kleist, 1999; Min, 1998; Cline and Barnes, 1997).

Table 3. Determinants of Spreads: Baseline Regression(3.1) (3.2) (3.3)

De jure De factoGrowth rate -1.43 -1.57 -1.75

(-2.07)� (-2.40)�� (-1.91)�

In�ation rate 0.67 0.65 0.68(2.96)��� (2.79)�� (2.14)��

Current account/GDP 0.64 0.29 0.48(0.99) (0.47) (0.64)

Trade Openness -0.67 -0.72 -0.46(-1.37) (-1.45) (-0.92)�

Financial Openness -0.58 -0.63 -0.73(-2.82)�� (-2.73)�� (-3.42)���

Reserves/GDP -5.05 -5.57 -5.45(-3.70)��� (-4.72)��� (-3.88)���

External debt/GDP 3.34 3.26 3.72(9.30)��� (8.63)��� (8.01)���

U.S. interest rate -0.01 -0.01 -0.01(-0.09) (-0.23) (-0.17)

Float 0.48 0.20(2.20)�� (0.71)

Intermediate 0.47 0.37(2.70)�� (2.40)��

Number of obs. 692 692 680Number of groups 21 21 21Adjusted R2 0.52 0.45 0.44Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%,(�) denotes 10% signi�cance.

The coe¢ cients of the exchange rate regime dummies show the relationship between

14

sovereign spreads and the degree of exchange rate �exibility. The "�oat" dummy shows the

e¤ect of having a �oating exchange rate regime relative to a �xed exchange rate regime and

the "intermediate" dummy shows the e¤ect of having an intermediate level of �exibility

relative to having a �xed exchange rate. When the de jure classi�cation is used both

dummy variables have positive and signi�cant coe¢ cients, which shows that announcing

a �oating exchange rate regime or an intermediate level of �exibility leads to signi�cantly

higher spreads than announcing a �xed exchange rate regime. When de facto regimes

are considered, the signi�cant positive e¤ect of intermediate regimes prevails. However,

with this classi�cation, there is no statistically signi�cant di¤erence in terms of sovereign

spreads between countries that keep their exchange rates �xed and those that have �oating

exchange rates, even though the coe¢ cient of the dummy for �oating exchange rates is still

positive. Therefore, when we take the announced regimes into account, countries that say

that they will follow a �xed exchange rate regime face lower sovereign spreads. When the

actual exchange rate behavior is considered, limiting the exchange rate �uctuations still

pays o¤ in terms of lower spreads compared to an intermediate level of �exibility, however,

in this case �exible exchange rates are not punished by higher spreads.

Intermediate level of exchange rate �exibility leading to higher spreads in the de facto

classi�cation is in contrast to the result in Jahjah and Yue (2004). They �nd that interme-

diate �exibility leads to lower spreads relative to a �oating exchange rate regime while there

is no di¤erence between �xed and �oating regimes. The sample means of sovereign spreads

reported in Table 2 also show that countries with de facto intermediate �exibility have a

lower mean spread compared to the other de facto groups. In order to further analyze this

�nding, the benchmark regression is repeated excluding variables that have a signi�cantly

di¤erent mean across the exchange rate groups, and among all of the regressors only the

reserves-to-GDP ratio reverses the sign of the intermediate dummy. When the regression is

run without this variable, the intermediate dummy has a negative coe¢ cient (see Table A2

in the appendix). The reserves-to-GDP ratio has the highest coe¢ cient among the regres-

15

sors and is highly signi�cant, therefore, its exclusion from the regressions has an important

e¤ect on the results. The sample mean of this variable is signi�cantly higher in the de facto

intermediate �exibility group compared to the �oating group, and it is close to the level

of the �xed exchange rate group. Therefore, when the e¤ect of this variable is controlled

for, the pure e¤ect of intermediate �exibility on spreads is positive but when this variable

is not included, the high level of reserves held by this group reduces the sovereign spreads

and the e¤ect of intermediate �exibility turns negative. In the second regression in Table

A2, the �nancial openness variable is excluded together with the reserves variable. In this

case, the negative e¤ect of intermediate �exibility becomes signi�cant, which explains the

di¤erence in results with Jahjah and Yue (2004).8

In the above regression with the de jure classi�cation, each country is assigned to an

exchange rate category for every quarter. However, in some quarters countries change their

exchange rate policy and announce a new regime. In such cases, the country is assigned

to the exchange rate category that has prevailed for the longest period of time during the

quarter in question. Since such a classi�cation may a¤ect the accuracy of the results, in this

part another dummy variable is used to represent these "transition" periods. The regression

results shown in the �rst column of Table 4 includes the dummy variable that represents

the quarters in which a country has partly followed a certain exchange rate regime, and

within that quarter switched to another regime. Hence, the dummy variables "�oat" and

"intermediate" in this regression exclude these time periods.

When the "transition" dummy is included in the regression, the coe¢ cients of the

dummies "�oat" and "intermediate" are still positive and signi�cant. The "transition"

dummy variable also has a signi�cantly positive e¤ect on sovereign spreads, which shows

that the periods of transition in exchange rate policy are associated with higher spreads.

It is sensible that the periods in which a country announces a new exchange rate policy

8When only the �nancial openness variable is excluded, the intermediate �exibility dummy still has asigni�cantly positive coe¢ icient. The reserves-to-GDP ratio is the only regressor that changes this resultby itself.

16

are the periods when it faces higher spreads, since countries may try to cope with turmoil

by changing their exchange rate policy. This variable may also be capturing the e¤ects of

some of the crisis episodes during which countries have changed their exchange rate policies

as the previously announced regime became unsustainable such as Argentina�s transition

from a currency board to a managed �oat at the end of 2001 or Turkey�s transition from

a crawling peg to an independently �oating regime in February 2001. The coe¢ cients of

the other variables are not a¤ected in terms of magnitude and signi�cance by this new

categorization.

A similar recategorization is also done for the de facto classi�cation. In the dataset

provided by IRR there are both monthly and quarterly classi�cations, and the quarterly

classi�cation is used in this paper. However, a country may exhibit di¤erent exchange rate

behavior within a quarter, which implies di¤erent categorizations for the months during

that quarter when the monthly classi�cation is used. As with the de jure classi�cation, the

quarters within which the de facto exchange rate classi�cation of a country has changed

are represented by a new "transition" dummy variable, and the regression results with this

dummy variable are shown in the second column of Table 4. The coe¢ cients of the exchange

rate dummies and the other explanatory variables are not a¤ected when the "transition"

dummy is included in the regression.

In the third column of Table 4, a 4-way exchange rate classi�cation is used for the de jure

classi�cation. The intermediate exchange rate category is divided into two separate groups

and each subcategory is represented by a dummy variable (the details of the categories are

given in the appendix). With this categorization, the "�oat" dummy still has a signi�cantly

positive e¤ect on sovereign spreads. The coe¢ cients of both of the new dummies are positive

and signi�cant, showing that intermediate �exibility leads to higher spreads regardless of

the level of �exibility, in the case of the de jure classi�cation.

17

Table 4. Determinants of Spreads: Di¤erent Categorizations(4.1) (4.2) (4.3) (4.4)De jure De facto De jure De facto

Growth rate -1.45 -1.70 -1.39 -1.78(-2.23)�� (-1.91)� (-2.34)�� (-1.93)�

In�ation rate 0.61 0.68 0.64 0.77(2.64)�� (2.07)� (2.79)�� (2.37)��

Current account/GDP 0.23 0.44 0.39 0.50(0.37) (0.59) (0.65) (0.66)

Trade Openness -0.71 -0.47 -0.65 -0.45(-1.46) (-0.93)� (-1.25) (-0.90)

Financial Openness -0.62 -0.73 -0.60 -0.72(-2.73)�� (-3.40)��� (-2.71)�� (-3.53)���

Reserves/GDP -5.65 -5.50 -5.50 -5.49(-4.95)��� (-3.92)��� (-4.70)��� (-3.95)���

External debt/GDP 3.27 3.72 3.22 3.73(8.82)��� (8.01)��� (8.48)��� (8.13)���

U.S. interest rate -0.02 -0.01 -0.03 -0.01(-0.27) (-0.17) (-0.48) (-0.15)

Float 0.51 0.24 0.52 0.01(2.49)�� (0.87) (2.17)�� (0.03)

Intermediate 0.49 0.41(3.02)��� (2.56)��

Transition 0.80 0.36(3.24)��� (1.57)

Intermediate1-4way 0.64 0.39(2.50)�� (2.68)��

Intermediate2-4way 0.43 0.08(2.25)�� (0.50)

Number of obs. 692 680 692 680Number of groups 21 21 21 21Adjusted R2 0.45 0.43 0.44 0.47Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%,(�) denotes 10% signi�cance.

18

When a similar 4-way classi�cation is used for the de facto classi�cation, the �oat

dummy still remains insigni�cant. Among the newly formed intermediate �exibility dum-

mies, the one that represents a lower level of �exibility has a positive and signi�cant coef-

�cient. However, the dummy variable that represents exchange rate behavior towards the

�exible end of the spectrum has an insigni�cant coe¢ cient. This result indicates that the

positive e¤ect of intermediate �exibility on sovereign spreads is mainly driven by more rigid

exchange rate behavior, implying a higher level of intervention by the monetary authority.

3.2 Robustness Checks

In order to check the robustness of the results, di¤erent variables that have been previously

used in the literature are added to the regressions as additional control variables. Using

these variables in the regressions reduces the number of observations and the number of

countries, which is the main reason for not including them in the baseline regression. The

variables that are analyzed in Table 5 are the ratio of investment to GDP, the ratio of debt

service to exports and the ratio of short term debt to total external debt.

Among the newly included variables, the ratio of investment to GDP has a negative and

highly signi�cant coe¢ cient. This variable is an indicator of the long-term growth potential

of a country and therefore, it would be expected to have a negative e¤ect on spreads. The

ratio of debt service to exports and the ratio of short term debt to total external debt are

expected to be positively related with default risk. With a high debt service to exports

ratio, sovereign debtors may face debt repayment problems. A high ratio of short term

debt is also perceived as a sign of potential liquidity problems, which is associated with the

possibility of a default. While the ratio of debt service to exports has a positive sign as

expected, the ratio of short term debt to total external debt has a negative sign. However,

both of these variables remain insigni�cant in all of the regressions.

19

Table 5. Determinants of Spreads: Additional Variables(4.1) (4.2) (4.3) (4.4) (4.5) (4.6)De jure De facto De jure De facto De jure De facto

Growth rate -0.89 -1.15 -1.35 -1.30 -1.43 -1.53(-1.68) (-1.60) (-2.21)�� (-1.87)� (-2.31)�� (-1.97)�

In�ation rate 0.53 0.60 0.76 0.77 0.74 0.70(2.17)�� (1.79)� (2.96)��� (2.22)�� (3.02)��� (2.12)��

Current account/GDP -0.95 -0.88 0.29 0.36 -0.03 0.12(-1.19) (-0.99) (0.46) (0.46) (-0.04) (0.16)

Trade Openness -0.72 -0.41 -0.71 -0.47 -0.62 -0.32(-1.47) (-0.82) (-1.40) (-0.98) (-1.47) (-0.75)

Financial Openness -0.58 -0.69 -0.86 -1.09 -0.93 -1.10(-2.78)�� (-3.91)��� (-2.64)�� (-3.61)��� (-3.12)��� (-3.95)���

Reserves/GDP -5.60 -5.56 -5.61 -5.45 -5.04 -4.95(-4.95)��� (-4.01)��� (-4.76)��� (-3.80)��� (-4.07)��� (-3.47)���

External debt/GDP 3.19 3.66 3.29 3.85 3.36 3.87(8.39)��� (8.07)��� (8.87)��� (8.52)��� (8.77)��� (9.33)���

U.S. interest rate 0.02 0.02 -0.05 -0.04 -0.03 -0.02(0.37) (0.41) (-0.90) (-0.61) (-0.55) (-0.28)

Investment/GDP -2.64 -2.83(-2.78)�� (-3.26)���

Debt service/Exports 0.51 0.33(1.71) (1.02)

Short term debt -1.23 -1.36(-1.18) (-1.24)

Float 0.47 0.21 0.64 0.47 0.61 0.37(2.13)�� (0.69) (2.84)�� (1.36) (2.94)��� (1.16)

Intermediate 0.47 0.39 0.61 0.51 0.58 0.52(2.64)�� (2.28)�� (3.35)��� (2.69)�� (3.41)��� (2.81)��

Number of obs. 654 642 645 633 645 633Number of groups 19 19 19 19 19 19Adjusted R2 0.44 0.42 0.46 0.46 0.47 0.46Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%, (�) denotes 10%signi�cance.

With the inclusion of these variables, the signs of most of the other explanatory vari-

ables are not a¤ected. Only the signs of current account-to-GDP ratio and U.S. interest

rate are reversed in some regressions but these variables still remain insigni�cant. The

20

signi�cance of most of the variables remain the same as well, with only the growth rate

becoming insigni�cant in the regressions that include the ratio of investment to GDP as an

explanatory variable. The relationship between the exchange rate dummies and sovereign

spreads does not change with the addition of these new variables, except that in some of

the regressions the signi�cance levels of the exchange rate dummies increase.

In order to analyze the e¤ects of �nancial crises on sovereign spreads, a dummy variable

that re�ects the crisis dates is used as an additional control variable in the regressions. The

results of these regressions are illustrated in the �rst two columns of Table 6.

The crisis dummy has been constructed by using the crisis dates given in Kaminsky

(2006) and Laeven and Valencia (2008). Kaminsky (2006) provides currency crisis dates

for 20 countries for the period from January 1970 to February 2002. Laeven and Valencia

(2008) provides a dataset that contains the timing of banking, currency and debt crises

for the period 1970 through 2007 for all countries. Since they use di¤erent methodologies

for identifying currency crises, the dates given in the two datasets do not always match

and in order to cover all periods, the crisis dummy is constructed by using all of the

dates given in the two papers. The sovereign spreads are expected to increase in the crisis

episodes, however, the crisis dummy has an insigni�cant coe¢ cient. This might re�ect

the fact that the e¤ect of �nancial crises on spreads is already captured by deteriorated

macroeconomic fundamentals, through the other explanatory variables. The coe¢ cients of

the other variables, including the exchange rate dummies, are not a¤ected by the inclusion

of the crisis dummy variable.

Table 6 also shows the regression results when the de facto exchange rate dummies

are constructed using the LYS classi�cation, which reduces the number of observations

substantially. In this regression, both the �oat dummy and the intermediate dummy have

signi�cantly positive coe¢ cients, albeit with a low signi�cance level. The coe¢ cients of

some of the other control variables change in terms of both the sign and the signi�cance

level in this regression as well.

21

Table 6. Determinants of Spreads: Crisis and LYS classi�cation(6.1) (6.2) (6.3)De jure De facto De facto-LYS

Growth rate -1.56 -1.77 -0.70(-2.21)�� (-1.90)� (-1.13)

In�ation rate 0.65 0.68 0.38(2.88)��� (2.15)�� (1.58)

Current account/GDP 0.29 0.48 0.31(0.47) (0.65) (0.88)

Trade Openness -0.72 -0.46 0.10(-1.44) (-0.91)� (0.23)

Financial Openness -0.62 -0.73 -0.003(-2.68)�� (-3.43)��� (-0.01)

Reserves/GDP -5.57 -5.46 -4.49(-4.74)��� (-3.88)��� (-2.64)��

External debt/GDP 3.26 3.73 1.97(8.65)��� (8.39)��� (6.17)���

U.S. interest rate -0.01 -0.01 0.22(-0.23) (-0.14) (4.27)���

Crisis Dummy 0.01 -0.07(0.05) (0.48)

Float 0.48 0.21 0.32(2.19)�� (0.73) (1.84)�

Intermediate 0.47 0.37 0.33(2.68)�� (2.41)�� (1.83)�

Number of obs. 692 680 468Number of groups 21 21 20Adjusted R2 0.45 0.44 0.53Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%,(�) denotes 10% signi�cance.

3.3 Fear of Floating

Estimation results given in sections (3.1) and (3.2) indicate that countries that announce

an intermediate level of �exibility and a free �oat face higher spreads in international

markets relative to the countries that announce a �xed exchange rate regime, controlling

22

for di¤erent factors. On the other hand, countries that actually let their exchange rates

freely �oat do not face higher spreads than countries that �x their exchange rates. It is

apparent from Table 1 that the two exchange rate classi�cations di¤er considerably and

countries that announce a �exible regime occasionally intervene and limit exchange rate

movements. In order to understand the implications of announcing a certain regime and

acting di¤erently, this section analyzes the e¤ects of having a de facto exchange rate regime

that is di¤erent from the de jure one. This analysis would also help understand the di¤erent

results obtained in the regressions when di¤erent classi�cations are used. In order to see

whether there is a punishment in terms of higher spreads for countries that do not follow

what they declare, a "fear of �oating" dummy variable is constructed to represent countries

that announce a more �exible regime than the one they actually follow. Hence, this variable

takes the value of one if the de jure classi�cation in a given period is �oating while the de

facto classi�cation is either intermediate �exibility or �xed, or if the de jure classi�cation is

intermediate while the de facto classi�cation is �xed. Including this variable in regressions

together with de jure exchange rate dummies gives the results illustrated in Table 7.

When the fear of �oating dummy variable is included in the regressions, the coe¢ cients

of the dummies "�oat" and "intermediate" for the de jure classi�cation exhibit the e¤ects

of announcing a �oating regime and intermediate �exibility relative to a �xed regime for

countries that actually follow these policies. On the other hand, the coe¢ cient of the fear

of �oating dummy shows the e¤ect of deviating from the announced regime towards a less

�exible exchange rate on sovereign spreads.

23

Table 7. Fear of Floating(7.1) (7.2) (7.3) (7.4)De jure De jure De jure De jure

Growth rate -1.95 -1.32 -1.46 -1.64(-2.09)�� (-1.81)� (-2.05)� (-2.14)��

In�ation rate 0.53 0.46 0.62 0.58(1.72) (1.48) (1.84)� (1.77)�

Current account/GDP 0.59 -0.74 0.47 0.22(0.78) (-0.82) (0.61) (0.29)

Trade Openness -0.42 -0.38 -0.43 -0.31(-0.82) (-0.76) (-0.89) (-0.74)

Financial Openness -0.75 -0.71 -1.10 -1.11(-3.46)��� (-3.98)��� (-3.64)��� (-3.95)���

Reserves/GDP -5.11 -5.19 -5.02 -4.47(-4.48)��� (-4.68)��� (-4.42)��� (-3.72)���

External debt/GDP 3.74 3.70 3.84 3.88(7.91)��� (8.23)��� (7.94)��� (8.84)���

U.S. interest rate -0.02 0.02 -0.05 -0.03(-0.31) (0.28) (-0.80) (-0.46)

Float 0.09 0.10 0.34 0.26(0.31) (0.34) (1.01) (0.85)

Intermediate 0.42 0.43 0.55 0.53(3.15)��� (3.00)��� (3.32)��� (3.52)���

Fof Dummy 0.35 0.32 0.25 0.30(1.59) (1.55) (1.19) (1.53)

Investment/GDP -2.78(-3.22)���

Debt service/Exports 0.37(1.15)

Short term debt -1.33(-1.25)

Number of obs. 680 642 633 633Number of groups 21 19 19 19Adjusted R2 0.44 0.43 0.47 0.47Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%,(�) denotes 10% signi�cance.

24

The results show that when the dummy variable for fear of �oating is included, the

�oat dummy loses its signi�cance while the intermediate dummy still has a signi�cant and

positive coe¢ cient. Therefore, among the countries that announce a �oating regime, those

that actually follow this policy do not face higher spreads. The positive e¤ect of the de

jure �oat dummy vanishes when the fear of �oating dummy is included, showing that this

positive e¤ect is driven by countries that do not follow the policy they announce. This is

consistent with the result about the de facto �oat dummy having an insigni�cant coe¢ cient

as seen in Table 3. The de jure intermediate dummy still has a signi�cantly positive

coe¢ cient, which is also consistent with the result that both the countries that announce

an intermediate �exibility and those that actually follow an intermediate �exibility face

higher spreads. The fear of �oating dummy has a positive coe¢ cient but it is insigni�cant.

These results are robust to the inclusion of additional control variables, which are the

investment to GDP ratio, the ratio of debt service to exports and the ratio of short term

debt to total external debt.

4 Conclusions

The exchange rate regime followed by a country acts as an important determinant of the

macroeconomic state of the economy. It is therefore expected to a¤ect the risk perceptions

of the international investors and the sovereign risk premium paid by an economy on

international borrowing. This paper empirically analyzes the e¤ect of exchange rate policy

on sovereign risk premia in emerging market economies.

The exchange rate policy pursued by a country can be quite di¤erent from the exchange

rate regime o¢ cially announced. This paper analyzes the e¤ects of both the declared regime

and the actual exchange rate policy on sovereign spreads. Therefore, the empirical analy-

sis is conducted using two di¤erent exchange rate classi�cations: a de jure classi�cation,

which is based on the exchange rate regimes o¢ cially announced by countries, and a de

facto classi�cation, which is based on observed exchange rate behavior. The regression

25

results for the de jure classi�cation are important in conveying information about how the

o¢ cial announcements a¤ect the risk perceptions of international investors. The de facto

classi�cation, on the other hand, shows the e¤ects of the actual exchange rate behavior on

risk premia. Therefore, this analysis helps reveal the di¤erences between the e¤ects of the

announced regimes and the observed exchange rate behavior on sovereign spreads.

The results of the empirical analysis show that the relationship between sovereign

spreads and the exchange rate regime changes with the classi�cation used. When the

de jure classi�cation is considered, countries that have a �oating regime or a regime with

an intermediate level of �exibility face higher sovereign spreads than countries that an-

nounce a �xed exchange rate regime. Therefore, announcing a peg lowers the spreads,

which is in line with the view that pegs are perceived as a commitment to maintaining

macroeconomic stability. When the de facto classi�cation is considered, countries with an

intermediate level of �exibility face higher spreads than countries with �xed exchange rate

regimes but in this case there is no di¤erence between �oats and pegs. Therefore, limiting

the exchange rate �uctuations completely or allowing the exchange rate to freely �oat is

better than having a limited level of �exibility in the sense of leading to lower borrowing

costs .

In order to better understand the di¤erences that are revealed by the empirical analy-

sis, the e¤ect of deviating from the announced policy is analyzed for countries that have

announced intermediate �exibility or �oating. The results show that the countries that

announce a �oating regime do not face higher spreads than pegs when they actually allow

a high degree of �exibility as they announced. Hence, the result about countries with a

�oating regime facing higher spreads is due to the countries that display "fear of �oating".

However, for the countries with an intermediate level of �exibility, the higher spreads are

not driven by the countries that do not follow this policy; intermediate �exibility leads

to higher spreads whether it is the announced or the followed policy. These results can

be interpreted as commitment to either a peg or a �oat reducing the possibility of discre-

26

tionary behavior, which in turn leads to lower spreads. Limited �exibility, on the other

hand, increases the uncertainty about monetary authorities�actions and leads to higher

borrowing costs.

Overall, this paper shows that exchange rate regime choice is a factor that a¤ects the

borrowing costs of emerging market economies. Countries that choose one of the two

extremes in terms of exchange rate behavior, a �xed exchange rate or a free �oat, are

rewarded by lower spreads compared to countries that allow an intermediate �exibility.

Hence, for countries that classify themselves as having a �oating regime, it is important

that they follow this policy since deviating from the announced policy leads to higher

spreads.

27

5 Appendix

Table A1. Sample Means of the Explanatory VariablesWhole De jure De factosample Fixed Interm. Float Fixed Interm. Float

Growth rate 0.034 0.035 0.044 0.027 0.037 0.038 0.015(0.002) (0.003) (0.004) (0.002) (0.003) (0.002) (0.005)

In�ation rate 0.095 0.091 0.125 0.074 0.111 0.074 0.147(0.009) (0.032) (0.011) (0.006) (0.037) (0.005) (0.020)

Current account/GDP -0.003 -0.007 -0.004 -0.001 -0.008 -0.002 -0.013(0.003) (0.007) (0.006) (0.003) (0.007) (0.003) (0.006)

Trade Openness 0.661 0.811 0.707 0.541 0.883 0.6189 0.533(0.013) (0.032) (0.025) (0.012) (0.037) (0.014) (0.033)

Financial Openness 1.280 1.299 1.406 1.168 1.330 1.257 1.216(0.016) (0.026) (0.036) (0.019) (0.030) (0.020) (0.036)

Reserves/GDP 0.161 0.200 0.175 0.130 0.186 0.167 0.088(0.003) (0.008) (0.006) (0.003) (0.009) (0.003) (0.006)

External debt/GDP 0.476 0.525 0.507 0.423 0.547 0.459 0.369(0.007) (0.011) (0.015) (0.011) (0.012) (0.008) (0.025)

Investment/GDP 0.217 0.222 0.229 0.206 0.221 0.221 0.196(0.002) (0.005) (0.004) (0.003) (0.005) (0.002) (0.006)

Debt service/Exports 0.233 0.190 0.219 0.274 0.189 0.258 0.203(0.006) (0.010) (0.008) (0.010) (0.011) (0.007) (0.016)

Short term debt 0.171 0.186 0.160 0.169 0.213 0.142 0.270(0.003) (0.007) (0.005) (0.005) (0.008) (0.003) (0.013)

Note: Standard errors are reported in parentheses.

28

Table A2.De facto De facto

Growth rate -1.61 -1.87(-1.71) (-1.66)

In�ation rate 0.65 0.99(1.51) (2.01)�

Current account/GDP 1.37 1.41(1.71) (1.38)

Trade Openness -0.44 -1.42(-0.76) (-2.01)�

Financial Openness -1.07(-3.31)���

Reserves/GDP

External debt/GDP 4.37 3.02(7.36)��� (5.83)���

U.S. interest rate 0.02 -0.01(0.32) (-0.14)

Float -0.20 -0.30(-0.70) (-1.17)

Intermediate -0.04 -0.26(-0.29) (-1.90)�

Number of obs. 680 680Number of groups 21 21Adjusted R2 0.42 0.47Note: Robust t-statistics are in parentheses. (���) denotes 1%, (��) denotes 5%,(�) denotes 10% signi�cance.

29

5.1 Exchange Rate Classi�cations

De jure classi�cation (using the IMF classi�cation):

- Fixed: Exchange arrangement with no separate legal tender, Currency board arrange-

ment, Conventional pegged arrangement, Pegged exchange rate within horizontal bands

(band narrower than or equal to +/-2%)

- Intermediate: Pegged exchange rate within horizontal bands (band wider than +/-

2%), Crawling peg, Crawling band, Managed �oating with no pre-announced path

- Float: Independently �oating

4-way classi�cation:

- Intermediate1: Pegged exchange rate within horizontal bands (band wider than +/-

2%), Crawling peg, Crawling band that is narrower than or equal to +/-2%

- Intermediate2: Crawling band that is wider than +/-2%, Managed �oating with no

pre-announced path

De facto classi�cation (using the IRR classi�cation):

- Fixed: No separate legal tender, Pre announced peg or currency board arrangement,

Pre announced horizontal band that is narrower than or equal to +/-2%, De facto peg

(Category 1 of the coarse classi�cation of IRR)

- Intermediate: Pre announced crawling peg, Pre announced crawling band that is

narrower than or equal to +/-2%, De facto crawling peg, De facto crawling band that is

narrower than or equal to +/-2%, Pre announced crawling band that is wider than or equal

to +/-2%, De facto crawling band that is narrower than or equal to +/-5%, Moving band

that is narrower than or equal to +/-2% (i.e., allows for both appreciation and depreciation

over time), Managed �oating (Categories 2 and 3 of the coarse classi�cation of IRR)

- Float: Freely �oating (Category 4 of the coarse classi�cation of IRR)

30

4-way classi�cation:

- Intermediate1: Pre announced crawling peg, Pre announced crawling band that is

narrower than or equal to +/-2%, De facto crawling peg, De facto crawling band that is

narrower than or equal to +/-2% (Category 2 of the coarse classi�cation of IRR)

- Intermediate2: Pre announced crawling band that is wider than or equal to +/-2%,

De facto crawling band that is narrower than or equal to +/-5%, Moving band that is

narrower than or equal to +/-2% (i.e., allows for both appreciation and depreciation over

time), Managed �oating (Category 3 of the coarse classi�cation of IRR)

5.2 Data Sources and De�nitions

- Sovereign spread: Emerging Markets Bond Index Global (EMBIG), J.P. Morgan.

- Growth rate: Annual growth rate of real GDP. Real GDP data from IMF�s Interna-

tional Financial Statistics database (IFS).

- In�ation rate: Annual in�ation rate measured by CPI. CPI data from IFS.

- Current account: IFS.

- International reserves: Total reserves minus gold, IFS.

- Openness: Exports plus imports divided nominal GDP, IFS.

- U.S. interest rate: Three-month U.S. Treasury-bill rate, IFS.

- Investment: Gross �xed capital formation plus changes in inventories, IFS.

- External debt: World Bank Quarterly External Debt Statistics Database. When

quarterly data are not available, annual data fromWorld Bank Global Development Finance

Database have been used. Quarterly data have been imputed from annual data as the

annual debt stock multiplied by the average exchange rate for the period, divided by the

annual GDP.

- Short term debt/Total external debt: Global Development Finance, World Bank.

31

- Debt service/Exports: Global Development Finance, World Bank.

- Gross stocks of foreign assets and liabilities: Updated and extended version of dataset

constructed by Lane and Milesi-Ferretti (2007).

Countries: Argentina, Brazil, Bulgaria, Chile, Colombia, Croatia, Ecuador, El Sal-

vador, Hungary, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia,

South Africa, Thailand, Turkey, Ukraine.

32

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