Democratization and Real Exchange Rates,

Published date01 May 2016
AuthorMartin Gächter,Bob Krebs,Benjamin Furlan,Harald Oberhofer
Date01 May 2016
DOIhttp://doi.org/10.1111/sjpe.12088
DEMOCRATIZATION AND REAL
EXCHANGE RATES
1,2
Benjamin Furlan*, Martin G
achter**, Bob Krebs*** and Harald Oberhofer****
ABSTRACT
In this article, we combine two so far separate strands of the economic literature
and argue that democratization leads to a real exchange rate appreciation. We
test this hypothesis empirically for a sample of countries observed from 1980 to
2007 by combining a difference-in-difference approach with propensity score
matching estimators. Our empirical results reveal a strong and significant find-
ing: democratization causes real exchange rates to appreciate. Consequently, the
ongoing process of democratization observed in many parts of the world is likely
to reduce exchange rate distortions.
II
NTRODUCTION
In recent years, one important aspect of trade policy discussions focused on
the issue of strategic manipulation of exchange rates. WTO trade negotiations
prior to the crisis, for instance, were accompanied by a lively discussion
whether China systematically undervalues its currency in order to establish
favorable exchange rates thus supporting its export-led growth strategy. These
so-called ‘unfair’ exchange rates exercise a direct impact on trade, as it can be
seen as an export subsidy or import tariff that provides trade advantages in
contrast to countries with ‘fair’ exchange rates.
3
Previous studies on this issue
*University of Salzburg
**Oesterreichische Nationalbank
***University of Innsbruck
****Vienna University of Economics and Business and Austrian Institute of Economic
Research (WIFO)
1
The views expressed in this article do not necessarily reflect the official viewpoint of the
Oesterreichische Nationalbank or of the Eurosystem.
2
The authors thank the editors in charge of our submission, Prof. Tim Barmby and Prof.
Catia Montagna, two anonymous referees as well as conference participants at the Annual
Meeting of the Austrian Economic Association in Vienna (2012), at the Annual Meeting of
the European Public Choice Society in Zurich (2013), at the FIW research conference in
Vienna (2013) and seminar participants at the Universities of Innsbruck and Salzburg for
very helpful comments on earlier versions of the paper. Benjamin Furlan and Harald Ober-
hofer also gratefully acknowledge financial support for this research provided by the Aus-
trian National Bank (Jubil
aumsfonds), grant number 14383.
3
The literature usually refers to ‘fair’ exchange rates if the nominal equals the real
exchange rate. In other words, the exchange rate is assumed to be fair if it is neither under-
nor overvalued.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12088, Vol. 63, No. 2, May 2016
©2015 Scottish Economic Society.
216
primarily focused on economic variables influencing the real exchange rate,
such as terms of trade, net foreign assets or real interest rates of countries. On
the contrary, political and institutional characteristics so far played only a
minor role in explaining real exchange rate movements. This is astonishing
because political decision-makers are able to directly control the currency of a
country, for instance, by following an expansionary monetary policy.
While previous studies do not provide a direct link between democracy and
real exchange rates, earlier research considers the role of democracy in pro-
moting free trade. Kono (2006), for example, argues that the spread of democ-
racy supports economic development, which in turn promotes economic
interdependence (Frankel and Romer, 1999). In a similar manner, some
papers show that democracies trade more than autocracies (e.g., Bliss and
Russett, 1998), and are more likely to conclude trade agreements (Mansfield
et al., 2002). In fact, the result that democratization promotes trade openness
is among the most robust in the field of international political economy.
Surprisingly, however, the impact of democratization on (real) exchange
rates has not been investigated in the literature. This article presents a first
attempt to investigate whether democratization exerts an impact on a coun-
try’s real exchange rate. More precisely, we link two separate strands of the
economic literature: the literature on political determinants of trade, portfolio
flows or foreign direct investment (FDI) on the one hand (see, e.g., Li and
Resnick, 2003; Yu, 2010), and the literature that examines the relationship of
these latter variables with the (real) exchange rate (see, e.g., MacDonald,
1998) on the other hand. As explained below, the main reasons for a currency
appreciation following democratization may stem both from the current
account (increased exports and potentially decreased imports) as well as the
financial account (as democratization is associated with increased FDI and
portfolio inflows). An alternative explanation for the positive relationship
between democratization and changes in exchange rates could be rooted in
the BalassaSamuelson effect, which implies that faster economic growth trig-
gers exchange rate appreciation. Given the large literature on the relationship
between democracy and real GDP growth (see, among others, Barro, 1996;
Heo and Tan, 2001; Plumper and Martin, 2003; Papaioannou and Siourounis,
2008) which (at least partly) shows that democratization induces GDP growth,
this catching-up process is also likely to induce real exchange rate
appreciation.
In our econometric analysis we combine a difference-in-differences (DID)
approach with propensity score matching (PSM) estimators. The latter allows
to overcome both the unobserved counterfactual problem and non-random
selection into democratization while the DID estimator additionally controls
for unobserved time-invariant heterogeneity across democratizing and non-
democratizing countries. Empirically, we utilize a sample of countries from
1980 to 2007.
According to our empirical analysis, the process of democratization indeed
leads to an appreciation of the real exchange rate, and thus, reduces misalign-
ments in foreign exchange markets. This real exchange rate appreciation is
DEMOCRATIZATION AND REAL EXCHANGE RATES 217
Scottish Journal of Political Economy
©2015 Scottish Economic Society

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