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Political Instability and the Peso Problem

Javier Garcia-Fronti and Lei Zhang

CSGR Working Paper Series 197/06 

March 2006


In Latin American countries, political instability is not uncommon: in particular, the transfer of power is not always subject to normal terms of election. In these circumstances, market expectations must not only take into account the commitment of the present government, but also incorporate future decisions of its potential successor. This could increase country risk even when the incumbent government is fully committed to a pegged exchange rate, particularly if the successor government is known to be considering devaluation and strategic default.

We develop a model suitable for situations of political instability and substantial dollarisation --- both pervasive factors in emerging markets. The former has been studied by Alesina et al. (1996), who defines political instability as the tendency of a government to collapse (Using a sample of 113 countries for the period 1950 through 1982 they find that in periods of such instability growth is significantly lower than otherwise.); and Annett (2001) has shown how political instability in emerging markets is linked to racial and religion divisions. "Dollarization, defined as the holding by residents of foreign currency and foreign currency-denominated deposits at domestic banks'' has been at the centre of the debate on "original sin'' (Eichengreen & Hausmann 1999). Dollarisation may appear an attractive monetary regime for checking inflation, but if a country has an exchange rate misalignment, the possibility of a financial crisis becomes an issue (Calvo, 2002).

In the present model it is assumed that the country under analysis has two possible governments with different ideologies and policy preferences: the existing government, who is fully committed to maintaining the peg, and the successor government which has a low cost of switching to float. Market expectations of a change of government can undermine the effectiveness of the most committed policy-maker: and sovereign spreads can rise even when a currency board is fully supported by the current administration. This paper provides an explicit pricing of such risk when political instability is given exogenously.

The Argentinean crisis is used to illustrate the argument. Argentina had a fixed exchange regime and the contractual structure was very much dollarised (Galiani, Heymann & Tommasi 2002), with 2/3 of commercial debt in dollars (IADB, 2004) (Calvo, Izquierdo & Talvi 2003). This left Argentina very vulnerable to a sudden stop. Argentina in 2001 was in a fixed exchange rate regime with a completely committed and fully credible policy-maker to maintain it: Mr Cavallo. Nevertheless, during 2001 the country suffered high country risk and a deep financial crisis, see Figure 1. Hence the issue: why high country risk, even if the current government was fully committed to maintain the peg?

The confused nature of the transfer of power in the Argentine case is underlined by the fact that there were 5 presidents in 10 days: and that President Duhalde was only regarded as a care-taker, precluded from running for office when the next round of elections were held in 2003 (Bruno, 2004). Lack of political legitimacy, coming after capital flight had stripped off the central bank of its dollar reserves, could help to explain the chaotic end to convertibility. These could prove interesting extensions to the political economy approach adopted here.