PUBLIC DEBT MATURITY AND CURRENCY CRISES
| Author | Jun Wang,Paul Levine,Alex Mandilaras |
| Published date | 01 February 2008 |
| Date | 01 February 2008 |
| DOI | http://doi.org/10.1111/j.1467-9485.2008.00444.x |
PUBLIC DEBT MATURITY AND
CURRENCY CRISES
Paul Levine
n
, Alex Mandilaras
n
and Jun Wang
n
Abstract
The theory underlying the effect of debt structure on the probability of a currency
crisis and the slope of the yield curve was developed in Benigno and Missale
(2004). In this paper, we provide the empirical evidence to support their model’s
predictions. In a dynamic panel data framework, we produce generalized method of
moments estimates that give substantial support to the hypothesis that the role of
short-term debt depends on how a devaluation affects the reputation of the
policymaker and the real value of public debt. In addition to the empirical analysis,
we generalize the theoretical framework to allow for the presence of non-deflatable
debt and, for completeness, examine the case where the monetary authority can
fully commit itself to an escape clause monetary rule.
I Intro ductio n
The mainstream literature on the monetary authority credibility (see Backus and
Driffill, 1985 and Backus and Driffill, 1985b) argues that a defence of the fixed
parity can signal the authority’s ‘toughness’ towards inflation and thus improve
the credibility of the exchange rate regime. A more recent literature has re-
examined this issue in the context of a model economy in which there are
persistence effects from failing to devalue following an adverse supply effect. For
example, in Drazen and Masson (1994) there is persistence in unemployment
and defending the fixed parity leads to higher future unemployment, under-
mining the possibility that the currency peg will be maintained.
1
In Benigno and
Missale (2004) – henceforth BM – persistence is driven not by unemployment
but by debt. In both models if the degree of uncertainty about the government’s
preferences is low, resisting a currency crisis may in fact reduce the credibility of
n
University of Surrey
1
Drazen and Masson (1994) explain the apparently paradoxical result that defending the
parity may increase the likelihood of a future devaluation with an enlightening and entertaining
example. We recommend referring to the original article, but for the convenience of the reader
we summarize it here as well. In this example, a colleague is assumed to announce that in an
effort to lose weight he is planning to skip dinner. He then adds that as part of his dieting
strategy he has not eaten for 2 days. Had he not avoided consuming food for 2 days the
credibility of his announcement would be judged on its merits. But with several meals skipped,
one would expect the likelihood that he will eventually eat tonight to be greater.
Scottish Journal of Political Economy, Vol. 55, No. 1, February 2008
r2008 The Authors
Journal compilation r2008 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
79
the exchange rate regime. In this paper, we adopt BM’s framework and produce
new empirical work in order to see whether a result obtained for a European
Monetary System participant also generalizes to emerging markets.
Following BM’s approach, we employ a three-period stochastic version of the
Barro and Gordon (1983) model, where the probability of devaluation in each
period is derived from the monetary authority’s optimization problem.
Monetary policy is conducted in terms of an escape clause that specifies the
threshold value of a negative supply-side shock above which devaluation will
occur. We present a more general framework than BM for studying the
policymaker’s optimization problem that distinguishes between the commitment
and discretionary optimal escape clauses. We also extend BM’s model to allow
for non-deflatable debt, i.e., in addition to nominal debt the government issues
securities whose real returns cannot be eroded through an unexpected
devaluation.
First, we examine the complete information game where the central bank can
commit itself to a two-period escape clause rule. Minimization of the bank’s loss
function delivers the optimum solution, which we regard as a benchmark. Then,
still in a complete information game, we move to the case of discretionary policy
where the monetary authority cannot commit. In both cases, with debt
consisting of short-term (one-period) and long-term (two-period) components,
it is shown that defending the fixed parity increases the debt burden and thus the
probability of having to resort to future devaluation. However, this increase in
probability is less under commitment and disappears altogether as debt becomes
entirely short term. This is the debt burden effect. We also confirm the BM result
for discretionary policy that the probability of a first-period devaluation also
increases with the level of public debt and, more interestingly, with the share of
short-term debt. Comparison with the commitment case shows that the
discretionary two-period escape clause rules are sub-optimal and involve an
expected inflation bias. This can be lessened by the delegation of monetary
policy to a ‘tough’ (inflation-averse) central banker, but this relocates the
problem to one of establishing the credibility of such toughness.
This leads us to an asymmetric information game where the authority’s
preferences are not known to the private sector. The decision to devalue might
reveal a weak monetary authority, thus leading to inflationary expectations,
which in turn increase the likelihood of a future devaluation. This is the
signalling effect and this effect is important when there is substantial uncertainty
about the authority’s cost of devaluation and the total debt is small. Whether the
debt burden or the signalling effect prevails depends on the importance of debt
fundamentals relative to the extent of the authority’s credibility (signalling)
problem.
We focus on three key predictions of the theory. The first is that if the debt
burden effect dominates the signalling effect then defending the fixed parity
increases the debt burden and thus the probability of having to resort to future
devaluation. Second, in debt burden countries the likelihood of a first-period
devaluation increases with the share of short-term debt, as the incentive to
devalue and exploit the lower rate (which follows the devaluation) also increases
P. LEVINE, A. MANDILARAS AND J. WANG80
r2008 The Authors
Journal compilation r2008 Scottish Economic Society
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