The Political Origins of Exchange Rate Valuations*faculty.msb.edu/sw439/documents/QW...

The Political Origins of Exchange Rate Valuations*

Dennis P. Quinn

Stephen Weymouth

29 June 2016

ABSTRACT

The relative strength of a country’s currency is central to its economic performance. Real

exchange rate overvaluation and volatility are linked to macroeconomic instability and slower

growth, whereas undervaluation appears to promote growth. In this light, why do countries not

consistently maintain undervalued currencies? We propose that the offsetting inflationary and

growth effects of undervaluation lead countries with high levels of political competition to avoid

sustained undervaluation. Currency volatility, undervaluation, and overvaluation each harm

constituencies that can mobilize in competitive political contexts. We find that the degree of

competitiveness of political institutions, rather than other attributes of democratic institutions,

explains why countries do (or do not) undervalue their currencies, and why some countries

maintain stable currency values. Democratic societies with politics that favor consumers have

systematically, if modestly, overvalued exchange rates. Sustained bouts of competitive

devaluation (“currency wars”) are highly unlikely among democratic countries. (144 words)

* Previous versions were presented at the International Studies Association 56th Annual Convention,

February 18–21, 2015, in New Orleans, Louisiana and the Georgetown Mortara Political Economy

Workshop. We especially thank Marc Busch, Andres Kern, and Pietra Rivoli for comments. Maria

Toyoda was a coauthor on the ISA version of the paper, and we thank her, and hope she has time in the

future to rejoin the project.

1

The value of a country’s domestic currency relative to other countries’ currencies – its

real exchange rate – is central to the politics of globalization. The real exchange rate is politically

important because the distributional consequences of a depreciated (or appreciated) real

exchange rate are unequal: some economic actors win, while others lose. When the currency is

undervalued relative to others, exports are more competitive on global markets and thus tend to

increase, along with wages and employment among exporting firms and industries. And, when

the currency is overvalued, imports can surge, benefiting consumers but imperiling import-

competing firms and industries (Broz and Werfel 2014; Jensen, Quinn, and Weymouth 2015).

Governments have strong incentives to pursue undervaluation and avoid extensive

overvaluation, distributional concerns notwithstanding. Dani Rodrik and others examine the

impact of undervaluation on growth. In an influential paper, Rodrik (2008: 366) finds “an

increase in undervaluation boosts economic growth just as powerfully as a decrease in

overvaluation” (see also Berg and Miao 2010). Rapetti, Skott, and Razmi’s (2012) review of the

literature reports that the estimated positive growth effects of undervaluation are robust to

estimation techniques, samples, and data choices. Currency overvaluation, while attractive to

consumers, is linked to macroeconomic instability (Fischer 1993) and slower economic growth

(Easterly 2005; Rodrik 2008). Overvaluation is also associated with current account deficits and

balance-of-payments crises – all of which harm growth.1 Vieira et al. (2013) also find that

volatility in exchange rate valuations harms growth.

The global politics of exchange rate policy are highly contentious, as countries have an

incentive to promote exports and growth through manipulating their currencies. The

1 For a dissenting view, see Schroeder 2013.

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distributional consequences of such manipulation engender intense domestic and international

political division (Broz and Frieden 2006; Copelovitch and Pevehouse 2011). Autor, Dorn, and

Hanson (2013) link the rapid rise in U.S. imports from China – fueled in part by an undervalued

yuan – to the loss of millions of manufacturing jobs in the United States.2 Firms exporting from

an undervalued country become more internationally competitive, often prompting foreign

competitors to initiate demands for protection.3 The effect of monetary policy interventions on

the value of real exchange rates became particularly contentious after the global financial crisis

of 2008–09, when the U.S. Federal Reserve’s expansionary “quantitative easing” program,

undertaken to support U.S. economic recovery, precipitated a decline in the dollar. The resulting

decline in their own export competitiveness caused policymakers abroad to claim that the Fed

was engaged in “currency wars,” deliberately weakening the dollar to gain trade advantages.

In light of the evidence about the growth effects of undervaluation, and the seemingly

limited ability of trade partners to respond to sustained undervaluation by other countries, the

question arises: Why do some countries consistently maintain relatively neutral, and sometimes

even overvalued, currencies over time when sustained undervaluation appears to promote

economic growth?

2 Subramanian (2010) argues that China’s currency undervaluation policies, which cost U.S.

manufacturing jobs, harm growth prospects in other developing economies with similar factor

endowments due to displacement of their exported goods.

3 Steinberg and Shih (2012) argue that the demands of tradable industries in China for

undervaluation are strongest in the absence of other compensatory policies, such as export

subsidies.

3

We argue that the degree of competitiveness of political institutions – rather than other

attributes of democratic institutions – is the key to understanding why countries do (or do not)

undervalue their currencies for sustained periods, and why some countries maintain stable

currencies. Currency volatility, undervaluation, and overvaluation each harm constituencies that

can mobilize in highly competitive political contexts, a point we develop below. These

competing interests tend to neutralize over time through robust political competition. In contrast,

authoritarian regimes, which by definition have less political competition, are more likely to

experience greater volatility in their exchange rates and be better able to sustain currency

undervaluation.

Examining data on real exchange rate valuations between 1975 and 2011, we demonstrate

two novel findings. First, we find that countries with competitive political institutions are

particularly unlikely to have sustained currency undervaluation. The second is a strong negative

relationship between the competitiveness of democratic institutions and currency volatility. The

results hold in both ordinary least squares (OLS) and instrumental variable (IV) models using

global waves of institutional change as an instrument for competitive institutions. We find that

lower volatility and more neutral currency valuations correlate with other features of democratic

governance (e.g., checks and civil liberties), but the statistical significance of the estimated

effects of other features of democratic governance vanish once we account for the

competitiveness of democratic institutions.

Democratic countries are not homogenous in how they balance exporter and consumer

interests. An important implication of our argument is that – within highly competitive political

systems – the relative balance between producers and consumers will influence the degree of

undervaluation and overvaluation, respectively. Variation within democracies can be explained

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by the political influence of consumers relative to producers: sustained undervaluation is

particularly unlikely where consumers and the elderly (savers) represent a large constituency.

We find within-democracy heterogeneity in real exchange rates based on the relative political

weight of consumer interests, as captured by increases in the ratio of retired persons to the

working population, or the dependency ratio. Among democracies, the greater the strength of a

country’s consumer interests, the more overvalued the currency.

Our paper contributes to the literature that examines how political institutions affect

exchange rate policy. Steinberg (2015) demonstrates that state control over labor and financial

markets, a hallmark of authoritarian governance, enable the pursuit of undervaluation as a

growth strategy.4 Other work finds that weak democratic institutions contribute to instability and

greater currency volatility (Hays, Freeman, and Nesseth 2003, Freeman, Hays, and Stix 2000,

Weymouth 2011), and that autocracies rely on pegged exchange rates, a relatively transparent

commitment mechanism, as a substitute for political system transparency (Broz 2002).5 Our

contribution shows, for the first time, that competitive electoral institutions are negatively

associated with sustained undervaluation and contribute to more stable real exchange rates.

THE POLITICAL ECONOMY OF EXCHANGE RATE MANAGEMENT

Because the real exchange rate is a relative price, governments do not have complete control

over its movement. There is, however, widespread agreement that the real exchange rate can be

4 See also Steinberg and Malhotra 2014.

5 Guisinger and Singer (2010) show that democratic government commitments to an exchange

rate peg, when made, are indeed more credible. See also Leblang 1999; Frieden, Leblang, and

Valey 2010; Plümper and Neumayer 2011; Bearce and Hallerberg 2011.

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considered a policy variable because governments can – and do – influence it through a number

of direct and indirect policy instruments. Policymakers in some countries have been quite

successful at maintaining undervalued and overvalued exchange rates over long periods of time

(Rodrik 2008).

Intervention in the foreign currency market is the most direct action that governments can

take to influence the value of their own currency. Monetary authorities can buy or sell foreign

currency to affect the nominal value of the domestic currency. For instance, the central bank may

exchange domestic currency that it holds in reserves for foreign currency, potentially decreasing

the value of the domestic currency.

Less direct policy channels are often employed in combination. For example, restrictions

on capital flows (“capital controls”) may be used, such as when Chinese authorities employed

capital controls (particularly restrictions on capital outflows) to maintain a relatively undervalued

yuan. Capital control inflow restrictions have been used extensively to decrease inflows and

prevent currency appreciation (e.g., ‘sterilization’ accounts6 in Chile). Governments may also

rely in part on monetary policy. For instance, a sustained overvaluation will likely require

relatively high domestic interest rates, which attract investment and raise the relative value of the

domestic currency. Steinberg (2015) and Steinberg and Shih (2012) argue that China’s pursuit of

sustained undervaluation was possible in part due to state control of financial markets.

Governments also use fiscal policy to influence the real exchange rate. Increased public

spending or fiscal transfers (fiscal expansion) can cause prices to rise in nontradables, shifting

6 An example is when a firm is required to deposit inward funds in a non-interest bearing account

for six months prior to being able to import the funds.

6

resources to the production of nontradable goods, and thus putting upward pressure on the real

exchange rate (Iverson and Soskice 2010). Relatively restrictive fiscal policy, however, tends to

coincide with the maintenance of a competitive real exchange rate that encourages exports.7

Competitive Democratic Institutions Make Sustained Undervaluation Difficult

Given the strong association between sustained undervaluation and economic growth, it is

natural to ask why governments do not universally pursue a weak currency. The reason, we

contend, relates to competing interests as reflected through competitive political institutions. The

literature on the political economy of exchange rates demonstrates how exchange rate valuations

affect various social groups differently. The offsetting economic consequences of currency

undervaluation and overvaluation create formidable constituencies that seek to influence

exchange rate valuations in such a way as to achieve their own (often competing) goals.

For one, an “artificially” depreciated currency risks higher inflation as the prices of

imported consumer and input goods rise. Undervaluation makes tradables producers that

compete with foreign imports more competitive: their goods become relatively less expensive

compared to those from foreign competitors. This drop in competition may eliminate the

incentive for domestic producers to keep prices low, contributing to higher inflation if domestic

firms in undervalued countries increase their prices when competition from foreign firms is

7 As Eichengreen (2007) notes, the impact of fiscal policy on the real exchange rate depends on a

number of market conditions, including the level of private spending and investment.

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reduced.8 Conversely, an appreciated domestic currency increases import competition and

encourages firms to keep prices low. All else equal, a strong domestic currency will contribute to

lower inflation.

Second, a weak domestic currency diminishes the purchasing power of domestic

consumers. Thus, while some firms in tradable sectors might prefer an undervalued exchange

rate, the effects of undervaluation on prices may harm a large subset of consumers not employed

in the tradable sector.9 As described by Bates (1981), many post-colonial African countries

maintained overvalued exchange rates and restricted trade to increase the purchasing power of

urban consumers – much to the detriment of rural agricultural producers. We expect that

citizens’ consumption interests, particularly in democratic settings, strongly constrain

governments’ ability to maintain undervalued currencies.

While consumer and sectoral interests are salient in exchange rate policymaking, so too

are the likely divisions over the effects of undervaluation on individual firms. For instance, a

weak (depreciated) real exchange rate implies an increase in the price of tradable goods and

services relative to nontradables. For firms with large shares of outputs that are tradable relative

to their inputs, a cheaper currency implies an increase in profits (all else equal). Conversely,

8 Plümper and Neumayer (2011) show that exchange rate depreciations lead to a rise in inflation

due to increases in the prices of goods. Thus avoiding inflation is an important motivation for

countries with extensive import sectors.

9 Naio and Kume (2015) demonstrate that even individual who that are vulnerable to job losses

through imports can, through “consumption priming,” become more favorable to increased

imports.

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firms that rely largely on tradable inputs for the production of nontradable goods and services

will see a reduction in profits following the depreciation of the local currency (Frieden 2015;

Egan 2016). Empirical research supports this argument. For example, Broz, Frieden, and

Weymouth (2008) show that firms in tradable goods sectors are more likely to express concerns

about exchange rate appreciations owing to their deleterious effects on exports and the resulting

increase in imports. Egan (2016) demonstrates that firms with a high dependence on imported

inputs are dissatisfied with real depreciations.

Firm preferences regarding currency valuations are also influenced by the

microeconomic/balance sheet consequences of such valuations, which depend on the currency

composition of private debt. Walter (2008), for example, proposes that currency valuation

preferences do not derive solely from competitiveness concerns or price-based preferences, but

also from the vulnerability of firms’ balance sheets to depreciation and increased interest rates.

Firms with substantial debt denominated in foreign currency will oppose domestic currency

depreciation, all else equal.10

The fragmentation of production and trade across borders adds an additional layer of

complexity, since it may contribute to considerable heterogeneity in firm exchange rate

preferences, even among firms within the same industry (see Bearce and Tuxhorn forthcoming).

Firms increasingly produce abroad to take advantage of cheaper inputs (Helpman 1984). A

strong domestic currency makes the value of foreign assets relatively cheaper, thus lowering the

costs of investment by foreign firms (Blonigen 1997) and increasing the financial worth of

10 Moreover, highly leveraged firms and individuals will oppose the high interest rates that may

be required to maintain an overvalued currency.

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foreign bidders relative to domestic investors (Froot and Stein 1991). An important indirect

benefit of undervaluation may thus be that it induces resource-seeking forms of foreign direct

investment (FDI). For firms that use FDI as a platform for export, an undervalued host market

currency increases the competitiveness of their exports (Blonigen 1997). Thus, it is not clear that

the largest trading firms, which have value chains that extend around the world, will always

support a weak domestic currency (Jensen, Quinn, and Weymouth 2015).

In turn, the economic policy interests of highly globalized firms reflect the location and

scope of their global production activities. Jensen, Quinn, and Weymouth (2015) show that firms

establish production affiliates in countries with undervalued exchange rates: these firms are less

likely to pursue trade remedies when the domestic currency appreciates. This strategic adaptation

by international firms suggests that domestic currency fluctuations can be hedged by establishing

foreign affiliates for production and trade. As global value chains fragment, the exchange-rate-

level objectives of firms in the export sector become increasingly complex. In sum, the effect of

the real exchange rate on firm profitability depends on a number of factors that complicate ex

ante predictions of firms’ preferences regarding this rate.11

Since the economic consequences of real exchange rate valuations are potentially

countervailing, especially in the longer term, political economy considerations will influence

governments’ exchange rate valuation decisions. Both currency appreciation (which has adverse

growth consequences) and currency depreciation (which has inflationary, competitive, and

balance sheet pressures) are likely to generate unfavorable electoral consequences for political

11 Consumers in sectors that are relatively shielded from globalization (e.g., nontradable

services) are most likely to prefer a strong domestic currency that increases purchasing power.

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elites in democracies, as voters tend to punish both lower growth and higher inflation in

elections. The profits of firms engaged in trade and FDI will be strongly affected by the value of

the real exchange rate, but the location and scope of firms’ value chains imply strong divisions

among them, even potentially among those within the same sector.

Moreover, the complex and countervailing effects of exchange rate policies do not allow

for a simple division of preferences along traditional partisan policy prescriptions. For example,

leftist parties in small, open, export-dependent economies are unlikely to share exchange rate

policy preferences with leftist partisans in large relatively closed economies. Given the

fragmentation of global value chains, conservative parties with strong ties to global businesses

will also have heterogeneous preferences. We expect no systematic partisan policy differences

among democracies.

As a result of the offsetting distributional effects outlined above, we expect countries that

are more democratic (and thus have higher levels of political competition) to have more neutral

real exchange rate valuations, and are especially less likely to have undervalued currencies. The

democratic institutional environment defines the degree to which governments respond to the

preferences of diverse interests. In democracies, elections entail competition from credible

parties that represent constituents with opposing interests. To maximize political support,

governments in democracies are more likely to pursue exchange rate policies with broad appeal

(Bearce 2014).

On average, highly contested political markets are likely to produce a stalemate between

forces that favor undervaluation and those that seek to avoid inflation. Strong constituencies

opposing undervaluation will make the pursuit of sustained undervaluation policy untenable. In

11

contrast, authoritarian regimes seeking an export advantage through currency undervaluation can

more easily suppress consumer and worker demands for cheaper goods or higher wages.

While our emphasis is on the differences between competitive and non-competitive

electoral systems, we also account for the observed variation within competitive democracies.

We expect democratic societies with larger numbers of consumers relative to producers’ groups

to have an incentive for a modestly overvalued currency as consumer prices will be lower. In

turn, in democratic societies with larger numbers of economically active adults relative to

retirees, we expect greater demand for export competitiveness. In the latter societies, political

demands for a ‘strong’ currency (i.e., overvaluation) will be limited.

Other Attributes of Democratic Governance that Could Influence Exchange Rates

Along with competitive elections, democracy is associated with a broader set of institutions that

make sustained undervaluation difficult. We consider a number of alternative channels through

which democracies, and the constellation of institutions normally associated with them, may

influence the value of the real exchange rate over time.

First, almost by definition, democracies are more likely to allow labor to organize. As

Steinberg (2015) shows, undervaluation is more difficult when the state grants labor this right.

Labor’s ability to organize will lead to demands for higher wages, negating the benefits of

undervaluation for exporting firms.

Second, democracies promote the development and liberalization of financial markets

(Quinn 2000; Girma and Shortland 2008). As Steinberg (2015) demonstrates, state control over

the financial sector is central to its ability to pursue undervaluation as a growth strategy. One

reason is that countries that pursue undervaluation will often sterilize their foreign currency

interventions to offset the potential inflationary effects. These sterilizations are more difficult

12

when the state cannot force financial institutions to purchase its debt. Moreover, state control

over the financial system allows governments to channel cheap credit to the manufacturing

sector, thereby enhancing industry support for undervaluation (Steinberg 2015). To the extent

that democratic governments have less control over the financial sector than their autocratic

counterparts, policymakers in democracies have fewer policy instruments with which to achieve

for sustained undervaluation.

Third, democracies are less likely to maintain capital controls (Milner and Murkherjee

2009; Quinn and Inclán 1997), and capital account restrictions are a useful tool for sustaining a

particular level of exchange rate. Undervaluation, in particular, requires financial repression

(e.g., capital controls) to prevent rising domestic inflation.

A fourth channel through which democracies may influence the real exchange rate is

institutional checks and balances and other facets of decentralization or coalition formation,

which may make quick and radical reversals of policies harder (Henisz 2000; Nooruddin 2011).

Insofar as democratic governance is associated with independent central banks, clear monetary

rules, and other structures limiting executive power, governments with constrained executives or

many veto points might therefore be less likely to exhibit overvaluation or undervaluation. We

consider these as alternatives to the explanation that we have developed here.

Iversen and Soskice (2010) put forward a related “within” democracy argument. Of

relevance to our study, they argue that decreasing income inequality – measured as the ratio of

the incomes of the fifth decile wage earners to the bottom decile income earners – leads to

increasing currency valuations, as the basket of goods consumed by lower-income earners

13

includes a greater proportion of goods in the “sheltered” (i.e., nontraded) sector.12 We enter their

preferred inequality variable to control for this alternative explanation.

Democracy and Exchange Rate Stability

Along with the tendency toward more neutral exchange rate valuations, competitive political

environments will also lead policymakers to maintain less volatile real exchange rates. Part of

the democratic tendency toward real exchange rate stability is due to powerful firms’ underlying

interest in avoiding volatility. In particular, globally engaged firms will favor relatively stable

exchange rates because volatility poses risks to future cash flows.13 These risks increase with the

time horizon of the foreign currency exposure. Firms conducting only domestic business will be

less concerned about exchange rate stability, particularly to the extent that managing the

exchange rate entails a loss of monetary policy discretion under the assumption of mobile global

capital flows. While the intensity of interest in stability will vary depending on the extent to

12 The causal chain includes wage centralization in a coordinated bargain system, which results

in decreased wage dispersion: “the entire direct effect of centralization disappears, and wage

compression now explains much of the variance in real exchange rates….centralization raises the

real exchange rate and that much, if not all, of this effect runs through wage compression”

(Iversen and Soskice 2010: 617). We update the wage compression data for their 2.5 model from

16 to 34 countries and extend the sample to 2011 from 2000. See the OECD Electronic Data

Base on Wage Dispersion for the relevant data.

13 For more on the relationship between trade agreements and fixed exchange rates, see

Copelovitch and Pevehouse (2013).

14

which inputs and outputs are traded, it is safe to assume that almost no firms should favor

exchange rate instability per se.

Moreover, policymakers will likely be highly sensitive to citizens’ preference for

economic stability in democracies. One implication is that democratic leaders will actively

pursue policies that lead to less volatile real exchange rates compared to leaders in autocratic

regimes, even if democracies are less likely to implement de jure pegs (Bearce and Hallerberg

2011).14 Indeed, sustained de facto real exchange rate stability in democracies may be due in part

to their lower propensity to peg. The relatively frequent and spectacular collapses of pegged

exchange rates over the past several decades (e.g., Thailand, Russia, Korea) are consistent with a

negative association between democracy and exchange rate fixity (as demonstrated by Bearce

and Hallerberg 2011), but also with a subsequently higher incidence of de facto volatility in

countries with weaker democratic institutions.15

This “fear of floating” logic is entirely consistent with what we know about democratic

regimes. Policymakers in democracies fear economic instability, since it is tied to political

turnover (Quinn and Wooley 2001; Jensen, Quinn, and Weymouth 2016). Consequently, highly

contested political markets are likely to lead policymakers to avoid exchange rate volatility.

14 Bearce and Hallerberg (2011) propose that contested political markets should partially explain

regime choice. Assuming that the median voter in democracies is a domestically oriented

producer who favors monetary policy autonomy over a pegged exchange rate, they argue that

democratic governments will be more likely to adopt flexible exchange rate regimes.

15 See also Bearce (2014).

15

Autocratic regimes and regimes in transition, by contrast, are likely to exhibit greater variance in

exchange rate policies.16

As with currency valuations, other aspects of democratic governance are likely to limit

exchange rate volatility, especially independent central banks, constrained executive powers, and

checks and balances. Unlike currency valuations, where the relative balance of consumers and

producers might produce within-democracy heterogeneity, no group benefits from exchange rate

volatility, and so we do not expect the balance of consumer versus producer interests to

systematically account for variation in real exchange rate volatility within democracies.

Summary and Empirical Implications

The empirical implications of our argument are as follows. We expect that democracies,

compared to autocracies, will tend toward more neutral real exchange rate valuations and will

avoid sustained undervaluation. We expect this result to be driven primarily by political

competition. Moreover, we expect that democracies will maintain more stable currency

valuations over time than will autocracies. Among countries with highly competitive electoral

institutions, those with more consumers than producers will tend toward greater overvaluation.

METHODS AND DATA

Computing Exchange Rate Valuations

16 Many prior studies show that autocratic regimes tend to be associated with currency

undervaluation, though the results are influenced by the compositions of the samples. For a

review and an attempt to unpack authoritarian preferences on exchange rate regimes and

valuations, see Steinberg and Malhotra (2014).

16

Using methodologies outlined in Rodrik (2008) and adapted from the International Monetary

Fund (2012), we compute country-specific indices of real exchange rate valuations using Penn

World Tables (PWT8.1; see Feenstra, Inklaar, and Timmer 2015).17 The real exchange rate can

be thought of as the price of tradables relative to nontradables. The Our valuation index captures

the unique yearly value of a country’s goods, relative to those in the United States at the

prevailing nominal exchange rate. To generate our valuation index, we first compute:

𝑅𝐸𝑅𝑢𝑛𝑎𝑑𝑗𝑖𝑡 = ln(𝑋𝑅𝐴𝑇𝑖𝑡 /𝑃𝑃𝑃𝑖𝑡 ). (1)

XRATit is the nominal exchange rate, and PPPit is the price index. Following Rodrik (2008), we

control for the Balassa-Samuelson effect (that the relative prices of nontradables tend to increase

with country wealth) using GDP per capita in a regression framework. The undervaluation index

is the residual (𝜀̂ XRit) of the following regression:

𝑅𝐸𝑅𝑢𝑛𝑎𝑑𝑗𝑖𝑡 = 𝛼 + 𝛽ln𝐺𝐷𝑃𝑃𝐶𝑖𝑡 + + 𝛾𝑡 + 𝜀𝑖𝑡 (2)

where 𝛾𝑡 is a year fixed-effect term. A virtue of this approach is that the currency valuations of

all countries each year are estimated simultaneously in an equilibrium framework, allowing for a

comparison of the estimated values across countries and over time (cf. Cline and Williamson

2010). By convention, positive values of 𝜀̂ XRit denote undervaluation and negative values

denote overvaluation. The period examined is 1975–2011, which is post-Bretton Woods and

post-OPEC I.

17 The “output” version of income (RGDPo) is used as the U.S. price level is necessary to

compute the ratio of the home country price levels to the U.S. price levels.

17

We constructed a panel for up to 105 countries, from 1975 (or independence) to 2011, to

investigate the political institutional correlates of undervaluation and overvaluation. We use

democracy indicators from Polity IV (Marshall et al. 2013).18 In additional to Polity itself, we

employ two “concept” Polity variables: constraints on the executive (Exconst) and openness of

political competition (Polcomp). We also use the measures of political rights and civil liberties

taken from Freedom House and veto points (POLCON) from Henisz (2000).

OLS and IV models are estimated.19 We test for possible panel unit roots and

cointegration among variables. Because of persistence in the data, lags of the endogenous

variables necessary to produce serially uncorrelated residuals are employed (tested for using

panel Durbin’s m for AR1).

We estimate dynamic panel models of the undervaluation index. All of our models

include year dummies τt to account for global shocks and trends. The base five-year panel model,

with i = 1,2,...,105 and the index t representing a five-year period, from 1975 to 2011, is:

𝜀̂𝑋𝑅i,t = ß0 + ß1Yi,t-1 + ß2(GDP Growthi,t-1 ) + ß3(LogGDP/capitai,t-1) +ß4(Trade

Balancei,t-1 ) + ß5(LogTrade Opennessi,t-1 ) + ß6(Population Growthi,t-1 ) +

ß7(Eurozone Membershipi,t-1 ) + ß8(Capital Account Opennessi,t-1 ) + ß9(Political

Competitioni,t-1) + τt + i,t i=1,2,...,105. (3)

The economic control variables come from the Penn World Tables (either PWT 8.1 or

7.1). Capital Account Openness (CAPITAL) is a de jure measure of financial integration (see

Quinn 1997 and Quinn, Schindler and Toyoda 2011 for more complete description and

18 The data are currently available for 167 countries up to 2012.

19 IVREG2 from Baum, Schaffer, and Stillman (2010) is used for the IV models.

18

construction details). Eurozone Membership is a dummy variable that takes a value of 1 for

Eurozone countries.20 Political Competition captures the measures of democratic institutions

outlined above. The remaining variables are economic controls taken from the Penn World

Tables.

Along with the panel average value of the undervaluation index, (�̅�) 𝜀̂XR, we also model

volatility in the real exchange rates, which we measure as the standard deviation of the

undervaluation index over each five-year period, (σ) 𝜀̂XR.

Since it is difficult to control for the full set of factors that may correlate with political

institutions and the exchange rate, we estimate and report IV models for three reasons. First, this

approach alleviates concerns about endogeneity of democracy: a successful IV strategy can

account for the numerous potentially omitted variables that may affect both democracy and

subsequent undervaluation. Second, it can also help alleviate concerns about measurement error

in the democracy indicators. Third, the IV approach further addresses the issue of endogenous

changes in democracy scores.

Our IV strategy is to exploit global waves of democratization (and reversals) as a source

of exogenous variation in democracy. Our instrument for democracy is the lagged jackknifed

average of global democracy, which is the global average Polity (or Polcomp) score net of

country i. Our approach assumes that democratic governance spreads in global waves, but that

these waves do not affect the real exchange rate in country i except through their effects on

democracy in country i. Based on this logic, we use lagged values of global democracy net of

20 Since countries must meet accession requirements, this variable is also lagged such that the

period prior to membership is coded as 1.

19

country i as instruments for democracy in country i while also conditioning on lagged values of

our dependent variables and other covariates.21

RESULTS AND DISCUSSION

Figure 1 presents preliminary evidence for our propositions. It shows the average cross-section

values of exchange rates for 124 nations (Y axis) against the period volatility of the exchange

rates from 1975–2011. Countries are categorized by level of democracy into four groups:

democracies (Polity average scores 6 or greater), autocracies (Polity average scores -6 or less),

weak democracies (1-5), and weak autocracies (0 to -5). In keeping with convention, positive

values of currency valuation denote undervaluation and negative numbers denote overvaluation.

Zero on the Y axis denotes a neutral currency valuation. Despite extraordinary changes in the

world order during this 37-year period, countries with sustained autocratic institutions show far

greater volatility in exchange rates, and a greater propensity for undervaluation compared to

democratic countries.

Table 1 examines the underlying data for the full sample and for a ten-year average

(1998–2007) in terms of the sample means and variances for the average exchange rate valuation

(denoted by Average (�̅�) 𝜀̂XR) and the volatility of the exchange rate (denoted by Volatility (σ)

𝜀̂XR) for the four groupings. We confirm the inter-ocular analysis in Table 1, which reports the

t-test of means for the two variables of interest; the “base” category is highly democratic

countries, or those with period Polity average scores of 6 or higher. In Table 1, the sample

21 The strategy of using lagged global averages as an instrument for home country institutions

and practices is found in Acemoglu et al. (2015), Alquist and Wibbels (2012), and Quinn and

Toyoda (2007).

20

average is approximately zero, which corresponds to a neutral valuation. For highly democratic

countries, the average exchange rate volatility is low. Weak democracies also have average

valuations near zero, but volatility is much higher for the 1998–2007 period. For highly

autocratic regimes, the average undervaluation for the full period is 25%,22 but with much higher

average volatility and much higher sample variance for both volatility and exchange valuation.

We find a similar pattern for weak autocracies.

Table 1.

Exchange Rate Volatility and Valuation Averages: 1975–2011, 125 Countries

Sample Mean Sample

Strong

Autocracy

Weak

Autocracy

Weak

Democracy

Strong

Democracy

Volatility (σ) 𝜀̂XR 0.21 0.3*** 0.23*** 0.19 0.19

Average ( x )𝜀̂XR 0.03 0.22*** 0.01 0.08*** -0.08

Exchange Rate Volatility and Valuation Averages: 1998–2007, 145 Countries

Sample Mean Sample

Strong

Autocracy

Weak

Autocracy

Weak

Democracy

Strong

Democracy

Volatility (σ) 𝜀̂XR 0.15 0.23*** 0.16*** 0.15** 0.11

Average ( x )𝜀̂XR 0.01 0.38*** 0.13*** -0.02 -0.1

Notes: The table results are for t-tests of sample means, assuming unequal sample variances with

strong democracy (Polity period average score greater than six) as the benchmark case. The

range of the volatility and mean exchange rate variables are below 1. The sample average for

1975–2011 for Polity is 1.7, and the sample median is 1.4. Zero indicates a neutral valuation for

the average exchange rate measure. Positive numbers for the average exchange rate denote

undervaluation, and negative numbers denote overvaluation. * p-value < 0.10; ** p-value < 0.05;

*** p-value < 0.01.

To examine more rigorously the evidence, we next estimate OLS and two-stage least

squares (2SLS) models of the political and economic correlates of real exchange rate

undervaluation and volatility for up to 105 countries from 1975 to 2011, based on data

availability. Several panel unit root tests strongly reject the null hypothesis that all panels have

22 This is computed by exponentiating the average underlying valuation and subtracting 1.

21

unit roots.23 All specifications include year fixed effects and a lagged dependent variable, which

helped achieve serially uncorrelated residuals in all models reported.

Regression Results

Table 2 presents our baseline OLS and IV models. In Columns 1–4, the dependent variable is the

undervaluation measure. The results reported in Column 1 indicate a strong negative relationship

between the Polity measure of democracy and undervaluation, controlling for the number of

economic correlates of real exchange rates.24 In Column 2, we instrument for Polity using our

measure of global Polity, and the coefficient estimates are very similar to those reported in

Column 1.25 In Columns 3 and 4, we replace Polity with one of its concept variables, Political

Competition (Polcomp). The strong association between Polcomp the undervaluation measure is

robust to the use of global Polcomp as an instrument (Column 4). In identical samples, we find a

modest increase in the explanatory power of the models using Polcomp.

Columns 5–8 of Table 2 report the results of our models of real exchange rate volatility.

Consistent with our expectations, Polity and Political Competition are strongly negatively

associated with Volatility. We note, however, that the explanatory power of the models are

modest, and that one model only narrowly rejects that null of serial correlation.

Along with a lower propensity to undervalue, as demonstrated thus far, we are interested

in whether democratic political competition leads to sustained overvaluation or undervaluation.

In Column 9 we model sustained overvaluation, measured for each five-year panel as the average

23 We use IPS and Fisher ADF tests with trends, which are appropriate for unbalanced panels.

24 Summary statistics and a correlation matrix appear as Appendix Tables A1 and A2.

25 The first stage results appear in Appendix Table A3.

22

level of overvaluation for countries that maintain relatively overvalued currencies26 for all five

years of the panel. We find no statistically significant relationship between Polcomp and

sustained overvaluation. However, in the OLS and 2SLS models of sustained undervaluation27

reported in Column 10, we find that political competition makes sustained undervaluation less

likely. In sum, the relationship between competitive political institutions and currency valuation

is asymmetric: higher levels of political competition constrain governments’ ability to pursue an

undervalued currency, but do not necessarily lead to overvaluation compared to autocratic

regimes.28 Consistent with the patterns displayed in Figure 1, democracies rarely undervalue

their currencies and tend toward less volatility.

The control variables in Table 2 are not of direct interest, but we note that countries with

open capital accounts tend toward neutral valuation. Capital account openness appears to limit

sustained undervaluation in particular.

The models reported in Table 3 contrast the estimated effects of Polcomp with other

potential mechanisms through which democracies may influence exchange rate valuations. In

Column 1, we introduce the component index of Political Constraints (Exconst) from Polity.

Model 2 drops the Eurozone countries. In Model 3, we include Henisz’s POLCON 3 variable.

Models 4 and 5 include the Freedom House indicators of Civil Liberties and Political Rights,

26 Negative values of our index signify overvaluation.

27 This is measured as the average value of undervaluation for countries that maintain an

undervalued currency in each year of the five-year panel.

28 This finding perhaps helps identify a policy mechanism for the Chandra and Rudra 2015

finding that some autocratic countries maintain stable and higher growth rates.

23

respectively. Column 6 includes an index of Worker Rights. We examine partisan effects in

Column 7, constraining the sample to countries with the highest levels of political competition.

In Column 8 we include a measure of Central Bank Independence from Eichengreen (2014).

In all models, the sign and level of statistical significance of the estimated coefficient of

Polcomp is unchanged, and the magnitude of the estimate is either similar or larger to the base

models. The evidence strongly suggests that political competition – rather than other aspects of

democratic institutions – influences exchange rate valuations. Indeed, in results reported in

Appendix Tables A4 and A5, with Polcomp omitted, all of the other democracy or democracy-

related concept variables are separately statistically significantly correlated with neutral currency

valuations (except Central Bank Independence). When we include Polcomp in Table 3, however,

none of the variables is statistically significant except Exconst, which flips signs perversely. The

identifying variance appears to reside in the Political Competition variable.

In Table 4, we conduct a similar exercise to examine the correlates of real exchange rate

volatility. We find a similar pattern: political competition appears to be the primary channel

through which democracies produce more stable real exchange rates. Unlike the currency

valuation models, however, the estimated coefficient of Polcomp is not invariantly statistically

significant. This is an area of further investigation.

The models reported in Table 5 examine how the relative balance of consumer versus

producer interests influences exchange rate valuations, especially within democracies. In Column

1, including the age dependency ratio does not alter the level of statistical significance, sign, or

magnitude of the Polcomp coefficient. The dependency ratio has a negative and statistically

significant coefficient, which is consistent with modestly more overvaluation in societies with

larger numbers of consumers. Examining the valuation index among politically competitive

24

societies (Polcomp ≥ 8), we find, as expected, that increases in our proxy for consumer interests

– the dependency ratio – are associated with appreciations in the real exchange rate. Adding the

wage inequality measure from Iverson and Soskice (2010) in Column 3 produces a smaller

sample. We confirm their finding that wage compression is associated with currency

overvaluation.29 Given that we expect democracies to exhibit an overall tendency away from

undervaluation especially, but unconditionally away from overvaluation, we predict that the

estimated effects of the relative balance between producers and consumers will have a quadratic

functional form (as the incentives for lower prices will not be unlimited). The results indeed

show a quadratic form in a U shape.

Columns 4, 5, and 6 split the samples into three groups: highly competitive (Polcomp =

10), highly uncompetitive (Polcomp ≤ 2), and all others. Figure 2 shows the predicted values of

the valuation index in highly competitive societies based on Model 4. It shows that when

producer interests are relatively strong (i.e., when the age dependency ratio is low), democratic

countries have neutral currency valuations. However, as the number of consumers relative to

producers increases, the currency tends toward overvaluation. The marginal (dydx) effects (not

reported to save space) are no longer statistically significant beyond a dependency ratio of 22.

(The histogram of the density of observations is plotted on the figure.) Non-competitive

autocracies (purely autocratic societies, which tend to have much younger populations) tend to

exhibit sustained undervaluation. The sample of intermediate regimes shows no estimated effects

on currency valuations from the relative balance of producers and consumers.

29 Cf. Column 3 with their Model 2.5 (Iverson and Soskice 2010: 615).

25

CONCLUSION

In light of the overwhelming evidence linking real exchange rate undervaluation to faster

growth, it is natural to ask what constrains leaders from uniformly pursuing an undervalued

currency. We have found that that robust political competition moderates exchange rate

outcomes over the medium to long term. Sustained undervaluation and overvaluations both harm

constituencies that are central to winning elections in highly competitive political environments.

Political competition, rather than other institutional features or attributes, explains the democratic

tendency toward more neutral and stable currencies. Variation within democracies reflects the

relative balance of consumer versus producer interests. Politically competitive societies

dominated by consumers exhibit moderate levels of overvaluation, while those with relatively

more producers do not.

Our study suggests sustained bouts of competitive devaluations (i.e., currency wars) are

highly unlikely among democracies. In contrast, leaders in uncompetitive political systems are

less constrained by labor and consumer price demands, and less accountable for exchange rate

mismanagement leading to volatility. Thus, some autocratic countries are able to maintain

sustained currency undervaluation despite the costs to consumers and to worker wages, and tend

to exhibit more currency volatility. Sustained undervaluation appears to require repression of

political competition.

26

Figure 1. Real Exchange Rates by Regime Type

Figure 2. Consumer Interests and Predicted Currency Valuations in Democracies (based

on Model 4 of Table 5)

27

Table 2. Competition Political Institutions, Real Exchange Rate Valuations and Volatility – Five-Year Country Averages,

1975–2011

Note: Five-year country average values. The regressors are lagged by one period. The results of the first-stage estimates appear in the

Appendix. All models include period fixed effects. Durbin’s m assesses serial correlation in the panel; the null hypothesis is no serial

correlation. Robust standard errors adjusted for country-level clustering. * p-value < 0.10; ** p-value < 0.05; *** p-value < 0.01.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Dependent Variable:

sustained

overvaluation

OLS IV OLS IV OLS IV OLS IV OLS OLS IV

Lagged Valuation 0.7766*** 0.7824*** 0.7740*** 0.7812*** 0.3341*** 0.3434*** 0.2880***

(0.0241) (0.0239) (0.0244) (0.0244) (0.0460) (0.0398) (0.0309)

Lagged Volatility -0.0058 0.0132 -0.0054 0.0051

(0.0412) (0.0408) (0.0417) (0.0428)

GDP Growth 3.9673*** 3.0783* 4.0154*** 3.2519** -0.6657 -0.0902 -0.6635 -0.1145 1.7941 -0.6236 0.1811

(1.2786) (1.5864) (1.2552) (1.5699) (0.4330) (0.5221) (0.4395) (0.5418) (1.2989) (1.4017) (1.8143)

GDP per capita -0.0137* -0.0091 -0.0101 -0.0088 -0.0020 -0.0035 -0.0016 -0.0011 -0.0049 -0.0102 -0.0048

(0.0080) (0.0083) (0.0081) (0.0085) (0.0034) (0.0032) (0.0035) (0.0038) (0.0116) (0.0076) (0.0074)

Trade Balance 0.0002 0.0003 0.0001 0.0002 -0.0001 -0.0002 -0.0002 -0.0003 -0.0003 0.0005 0.0005

(0.0006) (0.0006) (0.0006) (0.0006) (0.0002) (0.0002) (0.0002) (0.0003) (0.0008) (0.0004) (0.0004)

Trade Openness -0.0098 -0.0078 -0.0110 -0.0075 0.0002 -0.0016 0.0003 -0.0025 -0.0172 0.0056 0.0010

(0.0108) (0.0107) (0.0106) (0.0106) (0.0041) (0.0040) (0.0041) (0.0041) (0.0109) (0.0105) (0.0113)

Population Growth 0.5673 1.0687** 0.5180 1.1836** 0.0771 0.0116 0.1030 -0.0480 2.0711*** -1.3948*** -1.0647**

(0.5240) (0.5083) (0.5032) (0.5068) (0.2462) (0.2500) (0.2454) (0.2606) (0.6982) (0.4116) (0.4451)

Eurozone Member 0.0241 0.0218 0.0230 0.0212 -0.0108* -0.0098* -0.0110** -0.0100* -0.0161 0.0697*** 0.0511***

(0.0151) (0.0153) (0.0149) (0.0152) (0.0055) (0.0056) (0.0055) (0.0055) (0.0193) (0.0240) (0.0172)

Capital Account Openness -0.0005* -0.0005* -0.0005* -0.0005* 0.0001 0.0001 0.0001 0.0002 0.0003 -0.0006***-0.0007***

(0.0003) (0.0003) (0.0003) (0.0003) (0.0001) (0.0001) (0.0001) (0.0001) (0.0003) (0.0002) (0.0002)

Polity -0.0033** -0.0036*** -0.0013*** -0.0012**

(0.0013) (0.0014) (0.0005) (0.0005)

Political Competition -0.0089*** -0.0069** -0.0027*** -0.0041** 0.0005 -0.0057** -0.0056*

(0.0026) (0.0034) (0.0010) (0.0017) (0.0022) (0.0022) (0.0031)

Constant 0.1662** 0.1268* 0.1818** 0.1531** 0.0860*** 0.0952*** 0.0946*** 0.0992*** -0.0683 0.2612*** 0.1468**

(0.0729) (0.0717) (0.0724) (0.0690) (0.0318) (0.0274) (0.0318) (0.0265) (0.0934) (0.0590) (0.0603)

Observations 732 688 732 688 627 584 627 584 732 732 688

Countries 105 105 105 105 105 105 105 105 105 105 105

Durbin's M (p-value) 0.45 0.99 0.44 0.99 0.31 0.38 0.28 0.06 0.8 0.75 0.82

R-squared 0.767 0.743 0.769 0.745 0.125 0.131 0.125 0.127 0.475 0.541 0.468

Adjusted R-squared 0.762 0.737 0.764 0.738 0.104 0.108 0.104 0.104 0.463 0.531 0.455

Valuation Volatility

sustained

undervaluation

28

Table 3. Democratic Institutions and Real Exchange Rate Valuations – Five-Year Country

Averages, 1975–2011

Note: Five-year country average values. The dependent variable is the average value of the

undervaluation index. The regressors are lagged by one period, with the exception of Central

Bank Independence, which is entered contemporaneously due to data limitations. All models

include the full sample except for Column 2 (which excludes Eurozone countries) and Column 7

(which includes only democracies). Durbin’s m assesses serial correlation in the panel; the null

hypothesis is no serial correlation. Robust standard errors adjusted for country-level clustering. *

p-value < 0.10; ** p-value < 0.05; *** p-value < 0.01.

(1) (2) (3) (4) (5) (6) (7) (8)

Lagged Valuation 0.7719*** 0.7776*** 0.7734*** 0.7743*** 0.7761*** 0.7654*** 0.7129*** 0.7552***

(0.0247) (0.0244) (0.0252) (0.0256) (0.0253) (0.0280) (0.0447) (0.0343)

GDP Growth 3.9788*** 3.9657*** 3.7502*** 3.7355*** 3.7218*** 3.0659** -2.9389 2.9184

(1.2417) (1.2937) (1.2873) (1.2933) (1.2872) (1.4272) (6.2773) (1.7871)

GDP per capita -0.0112 -0.0094 -0.0081 -0.0087 -0.0109 -0.0120 -0.0841** -0.0062

(0.0080) (0.0081) (0.0083) (0.0092) (0.0089) (0.0091) (0.0352) (0.0135)

Trade Balance 0.0001 0.0000 0.0000 0.0000 0.0001 0.0004 0.0046* 0.0005

(0.0006) (0.0006) (0.0006) (0.0007) (0.0006) (0.0007) (0.0023) (0.0010)

Trade Openness -0.0106 -0.0104 -0.0158 -0.0158 -0.0147 -0.0039 -0.0085 0.0068

(0.0104) (0.0109) (0.0113) (0.0113) (0.0115) (0.0123) (0.0205) (0.0197)

Population Growth 0.6415 0.5798 0.6328 0.6559 0.6729 1.1122** 1.3144 0.5060

(0.5072) (0.5040) (0.5044) (0.5221) (0.5068) (0.4978) (1.2853) (0.5308)

Eurozone Member 0.0218 0.0292* 0.0287* 0.0252* 0.0305* 0.0411** -0.1716***

(0.0150) (0.0150) (0.0150) (0.0151) (0.0157) (0.0164) (0.0377)

Capital Account Openness -0.0005* -0.0005* -0.0005* -0.0005* -0.0005* -0.0002 -0.0003 -0.0002

(0.0003) (0.0003) (0.0003) (0.0003) (0.0003) (0.0003) (0.0007) (0.0004)

Political Competition -0.0138*** -0.0088*** -0.0090*** -0.0099** -0.0141*** -0.0131*** -0.0084*

(0.0037) (0.0026) (0.0034) (0.0047) (0.0042) (0.0038) (0.0044)

Executive Constraints 0.0093*

(0.0052)

Polcon -0.0070

(0.0507)

Civil Liberties 0.0016

(0.0108)

Political Rights 0.0099

(0.0082)

Worker Rights 0.0002

(0.0152)

Partisanship -0.0051

(0.0097)

Central Bank Independence -0.0024

(0.0040)

Constant 0.1746** 0.1731** 0.1776** 0.1782** 0.1806** 0.1832** 0.8844** 0.0482

(0.0714) (0.0723) (0.0762) (0.0771) (0.0763) (0.0755) (0.3634) (0.0947)

Observations 732 687 688 688 688 583 181 297

Countries 105 104 100 100 100 104 34 75

Durbin's M (p-value) 0.51 0.39 0.5 0.5 0.54 0.72 0.87 0.11

R-squared 0.770 0.758 0.768 0.768 0.769 0.782 0.811 0.810

Adjusted R-squared 0.764 0.753 0.762 0.762 0.763 0.776 0.794 0.801

29

Table 4. Democratic Institutions and Real Exchange Rate Volatility – Five-Year Country


Note: The dependent variable is the standard deviation of the undervaluation index. The

regressors are lagged by one period, with the exception of Central Bank Independence, which is

entered contemporaneously due to data limitations. All models include the full sample except for

Column 2 (which excludes Eurozone countries) and Column 7 (which includes only

democracies). Durbin’s m assesses serial correlation in the panel; the null hypothesis is no serial

correlation. Robust standard errors adjusted for country-level clustering. * p-value < 0.10; ** p-

value < 0.05; *** p-value < 0.01.

(1) (2) (3) (4) (5) (6) (7) (8)

Lagged Volatility -0.0054 -0.0010 -0.0090 -0.0081 -0.0095 -0.0339 -0.1444* 0.0143

(0.0418) (0.0428) (0.0446) (0.0445) (0.0444) (0.0461) (0.0821) (0.0564)

GDP Growth -0.6693 -0.6875 -0.6807 -0.6600 -0.6884 -0.9903* -1.6611 -0.0906

(0.4386) (0.4448) (0.4487) (0.4444) (0.4478) (0.5116) (1.3990) (0.7624)

GDP per capita -0.0017 -0.0015 -0.0017 -0.0005 -0.0020 -0.0023 -0.0385*** -0.0043

(0.0035) (0.0035) (0.0036) (0.0036) (0.0036) (0.0041) (0.0101) (0.0075)

Trade Balance -0.0002 -0.0002 -0.0001 -0.0001 -0.0001 -0.0002 0.0014** 0.0005

(0.0003) (0.0002) (0.0002) (0.0002) (0.0002) (0.0004) (0.0005) (0.0005)

Trade Openness 0.0003 0.0005 0.0018 0.0018 0.0019 -0.0008 -0.0092 -0.0036

(0.0041) (0.0042) (0.0043) (0.0042) (0.0043) (0.0049) (0.0061) (0.0064)

Population Growth 0.1140 0.1146 0.1827 0.1663 0.1833 0.1503 -0.7028* -0.4202

(0.2486) (0.2479) (0.2521) (0.2512) (0.2506) (0.2548) (0.3726) (0.3047)

Eurozone Member -0.0110** -0.0123** -0.0111* -0.0129** -0.0128** 0.0026 -0.0047

(0.0055) (0.0059) (0.0057) (0.0057) (0.0064) (0.0067) (0.0115)

Capital Account Openness 0.0001 0.0001 0.0001 0.0001 0.0001 0.0002 0.0001 0.0002

(0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0002) (0.0002)

Political Competition -0.0031* -0.0027*** -0.0024* -0.0009 -0.0031** -0.0036** -0.0015

(0.0017) (0.0010) (0.0013) (0.0016) (0.0015) (0.0014) (0.0019)

Executive Constraints 0.0008

(0.0025)

Polcon 0.0006

(0.0194)

Civil Liberties -0.0040

(0.0032)

Political Rights 0.0014

(0.0026)

Worker Rights 0.0064

(0.0057)

Partisanship 0.0023

(0.0040)


(0.0025)

Constant 0.0939*** 0.0926*** 0.0906*** 0.0902*** 0.0910*** 0.1424*** 0.4935*** 0.1513***

(0.0323) (0.0318) (0.0334) (0.0331) (0.0333) (0.0356) (0.1083) (0.0550)

Observations 627 595 588 588 588 479 154 225

Countries 105 104 100 100 100 104 33 75

Durbin's M (p-value) 0.38 0.37 0.38 0.22 0.45 0.02 0.92 0.38

R-squared 0.126 0.108 0.124 0.126 0.124 0.139 0.345 0.108


30

Table 5. Consumer Interests and Real Exchange Rate Valuations in Democracies versus

Non-Democracies – Five-Year Country Averages, 1975–2011

Note: Five-year country average values. The regressors are lagged by one period, with the

exception of Inequality, which is entered contemporaneously due to data limitations. Autocracies

are defined as countries with Polcomp scores less than or equal to 2; intermediate regimes are

those with Polcomp greater than 2 and less than 9. Durbin’s m assesses serial correlation in the

panel; the null hypothesis is no serial correlation. Model 5.5 has a second lagged of the

dependent variable entered (not reported) to achieve uncorrelated residuals. Robust standard

errors adjusted for country-level clustering. * p-value < 0.10; ** p-value < 0.05; *** p-value <

0.01.

(1) (2) (3) (4) (5) (6)

full sample polcomp > 8 polcomp > 8 polcomp = 10 autocracies intermediate

Valuation 0.7694*** 0.7861*** 0.6506*** 0.7057*** 0.892*** 0.7376***

(0.0249) (0.0303) (0.0429) (0.0381) (0.11) (0.0531)

GDP Growth 4.0793*** 0.8564 -14.2849** -6.5827 2.435 4.6236**

(1.2772) (2.6650) (5.8114) (4.8077) (3.912) (1.7838)

GDP per capita -0.0041 0.0154 -0.0269 -0.0120 -0.001 -0.0066

(0.0084) (0.0173) (0.0302) (0.0281) (0.026) (0.0227)

Trade Balance -0.0000 -0.0005 0.0023 0.0001 -0.0006 -0.0009

(0.0006) (0.0008) (0.0016) (0.0018) (0.0010) (0.0008)

Trade Openness -0.0133 -0.0041 -0.0121 -0.0233 -0.024 0.0082

(0.0107) (0.0153) (0.0171) (0.0178) (0.028) (0.0214)

Population Growth -0.0859 -1.0136 -4.2974*** -4.9305*** 0.605 1.2512

(0.6317) (1.0447) (1.2605) (1.5598) (0.732) (1.3696)

Eurozone Member 0.0324** 0.0307* 0.0447*** 0.0445*** -0.1331

(0.0144) (0.0156) (0.0142) (0.0152) (0.1170)

Capital Account Openness -0.0004 -0.0002 -0.0002 -0.0004 -0.001 -0.0003

(0.0003) (0.0004) (0.0006) (0.0006) (0.001) (0.0004)

Old Age Dependency Ratio -0.0025* -0.0157* -0.0360*** -0.0368*** 0.011 0.0120

(0.0015) (0.0080) (0.0093) (0.0090) (0.025) (0.0247)

Political Competition -0.0086***

(0.0026)

Old Age Dependency Ratio (squared) 0.0003 0.0007*** 0.0007*** -0.000 -0.0003

(0.0002) (0.0002) (0.0002) (0.001) (0.0008)

Inequality 0.1466***

(0.0378)

Constant 0.1710** 0.0019 0.4866** 0.6489** 0.063 -0.0288

(0.0716) (0.1474) (0.2284) (0.2423) (0.213) (0.1331)

Observations 732 420 147 224 103 238

Countries 105 81 35 37 38 69

Durbin's M (p-value) 0.49 0.35 0.81 0.82 0.34 0.72

R-squared 0.770 0.758 0.877 0.835 0.790 0.728

Adjusted R-squared 0.764 0.748 0.860 0.822 0.764 0.707

31

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35

Proposed Online Appendix

The Political Origins of Exchange Rate Valuations

Table A1. Summary Statistics

Variable Obs Mean Std. Dev. Min Max

Valuation 732 -0.02 0.33 -1.24 1.56

Volatility 732 0.08 0.06 0.00 0.41

Polity 732 3.07 6.96 -10 10

Political Competition 732 6.48 3.46 1 10

Trade Openness 732 3.96 0.66 2.06 6.04

Trade Balance 732 -2.68 12.94 -87.77 39.89

Population Growth 732 0.02 0.01 -0.05 0.12

GDP Growth 732 0.00 0.00 -0.04 0.04

Capital Account Openness 732 60.52 28.16 0 100

GDP per capita 732 8.68 1.16 5.78 11.05

Eurozone Member 732 0.04 0.20 0 1

Executive Constraints 732 4.82 2.19 1 7

Polcon 688 0.28 0.21 0 0.71

Civil Liberties 688 4.66 1.72 1 7

Political Rights 688 4.70 2.04 1 7

Worker Rights 583 1.08 0.67 0 2

Partisanship 485 2.09 0.85 1 3

Inequality 151 1.71 0.23 1.30 2.50

Central Bank Independence 297 5.44 3.17 0 14.50

Old Age Dependency Ratio 732 11.74 6.74 2.90 32.11

36

Table A2. Correlations

Valuation Volatility Polity

Political

Competition

Trade

Openness

Trade

Balance

Population

Growth

GDP

Growth

Capital

Account

Openness

GDP per

capita

Eurozone

Member

Executive

Constraints Polcon

Civil

Liberties

Political

Rights

Worker

Rights Partisanship Inequality

Central Bank

Independence

Old Age

Dependency

Ratio

Valuation 1

Volatility 0.07 1

Polity -0.27 -0.21 1

Political Competition -0.29 -0.23 0.95 1

Trade Openness -0.03 -0.14 0.07 0.10 1

Trade Balance -0.02 0.00 0.11 0.08 0.03 1

Population Growth 0.01 0.13 -0.47 -0.45 -0.09 -0.15 1

GDP Growth 0.28 -0.21 -0.02 -0.02 0.11 -0.06 -0.06 1

Capital Account Openness -0.35 -0.19 0.49 0.52 0.36 0.16 -0.30 -0.01 1

GDP per capita -0.28 -0.20 0.54 0.55 0.27 0.45 -0.48 0.02 0.57 1

Eurozone Member -0.24 -0.14 0.23 0.24 0.16 0.07 -0.20 -0.06 0.30 0.32 1

Executive Constraints -0.23 -0.20 0.96 0.88 0.08 0.10 -0.48 0.00 0.47 0.55 0.23 1

Polcon -0.23 -0.21 0.80 0.78 0.06 0.10 -0.43 0.05 0.42 0.48 0.22 0.79 1

Civil Liberties -0.38 -0.19 0.87 0.86 0.10 0.15 -0.44 -0.02 0.55 0.66 0.28 0.85 0.73 1

Political Rights -0.33 -0.16 0.91 0.88 0.03 0.12 -0.41 -0.02 0.50 0.60 0.26 0.89 0.77 0.94 1

Worker Rights -0.34 0.01 0.56 0.57 0.00 0.07 -0.32 -0.21 0.29 0.40 0.22 0.53 0.45 0.62 0.62 1

Partisanship 0.08 0.07 -0.24 -0.21 -0.09 -0.10 0.13 0.01 -0.23 -0.25 -0.05 -0.20 -0.28 -0.20 -0.23 -0.11 1

Inequality 0.56 -0.03 -0.24 -0.24 -0.02 -0.28 -0.03 0.36 -0.03 -0.32 -0.22 -0.18 -0.14 -0.25 -0.17 -0.49 -0.10 1

Central Bank Independence -0.36 -0.24 0.59 0.55 0.11 0.15 -0.27 -0.18 0.47 0.62 0.06 0.60 0.43 0.68 0.62 0.32 -0.09 -0.28 1

Old Age Dependency Ratio -0.30 -0.21 0.58 0.57 0.12 0.17 -0.71 0.01 0.51 0.72 0.42 0.59 0.53 0.67 0.62 0.45 -0.16 -0.35 0.53 1

37

Table A3. First-Stage IV Models

Note: First-stage estimates for corresponding Models 2, 4, 6, 8, and 11 of Table 2. The

Kleibergen-Paap test of underidentification assesses whether the instruments are “weak” for the

endogenous regressor; the null is that the instruments are weak. Hansen’s J assesses whether the

instruments are correlated with the error term; the null is no correlation.

(1) (2) (3) (4) (5)

Lagged Valuation -0.2020 0.0684 0.0684

(0.2056) (0.2905) (0.2905)

Lagged Volatility 1.4975 -2.0138

(1.1912) (1.6565)

GDP Growth 26.4075 28.7144 36.5692 26.7855 28.7144

(20.3330) (31.5300) (25.9214) (33.4219) (31.5300)

GDP per capita 0.1672 0.7513*** 0.2390 0.8133*** 0.7513***

(0.1370) (0.2543) (0.1570) (0.2697) (0.2543)

Trade Balance -0.0082* -0.0254** -0.0084* -0.0223* -0.0254**

(0.0042) (0.0107) (0.0046) (0.0117) (0.0107)

Trade Openness -0.0083 -0.2485 -0.0016 -0.1946 -0.2485

(0.0683) (0.2246) (0.0727) (0.2367) (0.2246)

Population Growth 5.2676 -31.3308** 9.9597 -36.6841* -31.3308**

(9.7449) (15.9195) (12.3224) (19.2775) (15.9195)

Eurozone Member 0.2647*** -0.0961 0.3247** -0.1721 -0.0961

(0.1001) (0.2251) (0.1507) (0.2497) (0.2251)

Capital Account Openness 0.0030* 0.0173*** 0.0019 0.0154** 0.0173***

(0.0018) (0.0067) (0.0019) (0.0066) (0.0067)

Global Polityt-1 -125.6890*** -124.1391***

(9.5696) (9.6750)

Global Polityt-2 -13.5038* -13.5931*

(8.0476) (8.1365)

Global Polityt-3 0.0727 -0.0594

(0.4254) (0.4903)

Global Polcompt-1 -26.9292** -25.3846** -26.9292**

(13.0004) (12.5206) (13.0004)

Global Polcompt-2 -29.6795** -27.7836** -29.6795**

(11.7405) (11.6192) (11.7405)

Global Polcompt-3 -9.6802*** -9.0984*** -9.6802***

(2.3886) (2.2789) (2.3886)

Constant 1897.7899*** 450.5926*** 1812.1583*** 404.6263*** 450.5926***

(31.8161) (155.2225) (34.2644) (146.7116) (155.2225)

Observations 688 688 584 584 688

Countries 105 105 105 105 105

Adjusted R-squared 0.9733 0.6919 0.9715 0.6803 0.6919

Kleibergen-Paap rk Wald F statistic 3934.1 19.75 2915.2 16.95 19.75

Hansen J overidentification (p-value) 0.40 0.51 0.34 0.16 0.59

38

Table A4. Democratic Institutions and Real Exchange Rate Valuations – Five-Year

Country Averages, 1975–2011

Note: Replications of Table 3, dropping Political Competition. Five-year country average values.

The dependent variable is the average value of the Undervaluation index. The regressors are

lagged by one period, with the exception of Central Bank Independence, which is entered

contemporaneously due to data limitations. All models include the full sample except for

Column 2 (which excludes Eurozone countries). Robust standard errors adjusted for country-

level clustering. * p-value < 0.10; ** p-value < 0.05; *** p-value < 0.01.

(1) (2) (3) (4) (5) (6) (7) (8)

Lagged Valuation 0.7802*** 0.7859*** 0.7767*** 0.7681*** 0.7743*** 0.7701*** 0.7639*** 0.7615***

(0.0238) (0.0239) (0.0251) (0.0255) (0.0254) (0.0281) (0.0275) (0.0356)

GDP Growth 4.0055*** 3.8981*** 3.9147*** 3.7572*** 3.7489*** 2.4840 1.2251 3.0457*

(1.2868) (1.3484) (1.3216) (1.3206) (1.3172) (1.5019) (1.5417) (1.8270)

GDP per capita -0.0150* -0.0200** -0.0117 -0.0081 -0.0100 -0.0220** -0.0350*** -0.0136

(0.0079) (0.0077) (0.0080) (0.0090) (0.0088) (0.0094) (0.0109) (0.0123)

Trade Balance 0.0003 0.0003 0.0001 0.0001 0.0001 0.0007 0.0012 0.0010

(0.0006) (0.0006) (0.0006) (0.0007) (0.0006) (0.0006) (0.0013) (0.0009)

Trade Openness -0.0082 -0.0044 -0.0125 -0.0122 -0.0135 0.0050 -0.0044 0.0112

(0.0107) (0.0109) (0.0112) (0.0114) (0.0116) (0.0115) (0.0138) (0.0200)

Population Growth 0.6690 1.0521** 0.7468 0.6875 0.8187 1.3724*** 0.6516 0.7897

(0.5161) (0.4838) (0.5105) (0.5134) (0.5009) (0.4858) (0.7958) (0.5474)

Eurozone Member 0.0249 0.0333** 0.0323** 0.0336** 0.0386** 0.0455*** -0.1807***

(0.0153) (0.0156) (0.0156) (0.0153) (0.0163) (0.0157) (0.0383)

Capital Account Openness -0.0006** -0.0007** -0.0006** -0.0005* -0.0006* -0.0004 -0.0009** -0.0002

(0.0003) (0.0003) (0.0003) (0.0003) (0.0003) (0.0003) (0.0004) (0.0004)

Executive Constraints -0.0078*

(0.0040)

Polcon -0.1065**

(0.0422)

Civil Liberties -0.0160**

(0.0063)

Political Rights -0.0109**

(0.0052)

Worker Rights -0.0310**

(0.0118)

Partisanship -0.0029

(0.0089)


(0.0037)

Constant 0.2024*** 0.1991*** 0.1742** 0.1879** 0.1838** 0.2058*** 0.3717*** 0.0493

(0.0730) (0.0716) (0.0749) (0.0755) (0.0758) (0.0772) (0.1153) (0.0992)

Observations 732 687 688 688 688 583 485 297

Countries 105 104 100 100 100 104 91 75

R-squared 0.766 0.753 0.765 0.766 0.765 0.775 0.794 0.807


39

Table A5. Democratic Institutions and Real Exchange Rate Volatility – Five-Year Country


Note: Replications of Table 4, dropping Political Competition. The dependent variable is the

standard deviation of the Undervaluation index. The regressors are lagged by one period, with

the exception of Central Bank Independence, which is entered contemporaneously due to data

limitations. All models include the full sample except for Column 2 (which excludes Eurozone

countries). Robust standard errors adjusted for country-level clustering. * p-value < 0.10; ** p-

value < 0.05; *** p-value < 0.01.

(1) (2) (3) (4) (5) (6) (7) (8)

Lagged Volatility -0.0012 0.0096 -0.0042 -0.0064 -0.0042 -0.0196 -0.0031 0.0205

(0.0411) (0.0423) (0.0442) (0.0447) (0.0448) (0.0437) (0.0566) (0.0554)

GDP Growth -0.6439 -0.6951 -0.6282 -0.6507 -0.6555 -1.1046** -0.8213 -0.0489

(0.4379) (0.4442) (0.4388) (0.4450) (0.4448) (0.4905) (0.4968) (0.7648)

GDP per capita -0.0027 -0.0050 -0.0026 -0.0005 -0.0018 -0.0054 -0.0092** -0.0059

(0.0034) (0.0034) (0.0036) (0.0037) (0.0036) (0.0043) (0.0045) (0.0071)

Trade Balance -0.0001 -0.0001 -0.0001 -0.0001 -0.0001 -0.0001 -0.0002 0.0006

(0.0002) (0.0002) (0.0002) (0.0002) (0.0002) (0.0004) (0.0005) (0.0005)

Trade Openness 0.0009 0.0023 0.0025 0.0021 0.0021 0.0016 -0.0023 -0.0027

(0.0042) (0.0044) (0.0043) (0.0042) (0.0043) (0.0049) (0.0050) (0.0065)

Population Growth 0.1100 0.2479 0.2111 0.1747 0.2172 0.1910 -0.0121 -0.3811

(0.2501) (0.2616) (0.2567) (0.2527) (0.2548) (0.2496) (0.3344) (0.2922)

Eurozone Member -0.0108* -0.0115* -0.0106* -0.0109* -0.0105* -0.0056 -0.0066

(0.0055) (0.0062) (0.0058) (0.0059) (0.0063) (0.0061) (0.0112)

Capital Account Openness 0.0001 0.0000 0.0000 0.0001 0.0000 0.0001 0.0000 0.0002

(0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0001) (0.0002) (0.0002)

Executive Constraints -0.0031**

(0.0014)

Polcon -0.0270*

(0.0146)

Civil Liberties -0.0056***

(0.0020)

Political Rights -0.0033*

(0.0018)

Worker Rights -0.0025

(0.0050)

Partisanship 0.0017

(0.0037)


(0.0024)

Constant 0.1015*** 0.1021*** 0.0899** 0.0908*** 0.0915*** 0.1503*** 0.1864*** 0.1533***

(0.0327) (0.0355) (0.0344) (0.0333) (0.0338) (0.0393) (0.0499) (0.0553)

Observations 627 595 588 588 588 479 416 225

Countries 105 104 100 100 100 104 90 75

R-squared 0.119 0.093 0.118 0.126 0.120 0.122 0.151 0.104


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