Mark S. Copelovitch Assistant Professor ... - Princeton University

Download PDF
4 downloads 1945 Views 293KB Size Report
Comment
2004, we find strong support for these hypotheses. These findings shed .... Preferential trade agreements and exchange rate regime choice. The proliferation of ...
TIES THAT BIND? PREFERENTIAL TRADE AGREEMENTS AND EXCHANGE RATE POLICY CHOICE

Mark S. Copelovitch Assistant Professor Department of Political Science and La Follette School of Public Affairs University of Wisconsin-Madison 306 North Hall, 1050 Bascom Mall Madison, WI 53706 [email protected] Jon C. Pevehouse Professor Department of Political Science University of Wisconsin-Madison 416 North Hall, 1050 Bascom Mall Madison, WI 53706 [email protected]

Paper prepared for the Politics of Preferential Trade Agreements Workshop at Princeton University, April 30-May 1, 2010. For comments on previous drafts we thank Bill Clark, Jeff Frieden, Layna Mosley, Thomas Oatley, Peter Rosendorff, David Singer, and participants at workshops at the Duke University and the University of Wisconsin – Madison.

ABSTRACT This paper examines the question of whether a country’s exchange rate policy choices are influenced by membership in preferential trade agreements (PTAs). We argue that PTAs, by constraining a government’s ability to employ trade protection, increase its incentives to maintain monetary and fiscal autonomy in order to manipulate the domestic political economy. Consequently, we contend that countries are less likely to adopt or sustain a fixed exchange rate when they have signed a PTA with their “base” country – the country to whom they have traditionally fixed the currency or the major industrial country to whom they have the most extensive trade ties. Likewise, countries that have signed a “base” PTA are also more likely to have a depreciated currency, as measured by the level of the real exchange rate. Using data on both the de jure and de facto exchange rate regime choices of up to 101 countries from 19752004, we find strong support for these hypotheses. These findings shed light on the complex relationship between different types of macroeconomic policies in the contemporary world economy. More broadly, they speak to the question of whether international agreements are credible commitment mechanisms when close policy substitutes exist at the domestic level.

1

Introduction The trade implications of exchange rate policy have long been an important topic of interest for both economists and scholars of international political economy (Frankel 1999, Rose 2000, Frieden and Broz 2001/2006, Ghosh, et. al. 2002, Levy-Yeyati and Sturzenegger 2003). Indeed, the canonical literature in economics on exchange rates emphasizes the reduction of currency risk as one of the keys reason why countries choose fixed exchange rates over more flexible regimes (Mundell 1961, McKinnon 1962, Kenen 1969). Pegging the exchange rate reduces or eliminates exchange rate risk and facilitates cross-border trade and exchange. In contrast, currency volatility creates uncertainty about cross-border transactions, adding a risk premium to the price of traded goods and international assets (Frieden 2008). Thus, fixed exchange rates enable a government to enhance the credibility of its commitment to international integration, thereby encouraging greater trade and investment. In addition to currency stability, the level of the exchange rate also has important traderelated implications, as it affects the relative price of traded goods in both domestic and foreign markets. Fluctuations in exchange rates can have substantial effects on domestic producers’ competitiveness in world markets: “In the case of a real appreciation, domestic goods become more expensive relative to foreign goods; exports fall and imports rise as a result of the change in competitiveness. Real depreciation has the opposite effects, improving competitiveness” (Frieden and Broz 2001, 331). Consequently, exchange rate movements have significant domestic distributional consequences. All else equal, exporters and import-competing industries lose from currency appreciation, while the nontradables sector and domestic consumers gain (Frieden 1991). Conversely, currency depreciations have the opposite effect, helping exporters

2

and import-competing firms at the expense of consumers and the nontradables sector (Frieden and Broz 2001). A variety of well-known historical and contemporary examples highlight these vital connections between trade and exchange rate policies. For example, the question of whether or not to adhere to the gold standard mobilized tradable goods producers and dominated political debates about economic policy in the United States and elsewhere during both the pre-1914 and interwar periods (Eichengreen 1992, Frieden 1993, Simmons 1994). Similarly, the United States’ large current account deficits in the late 1960s and early 1970s, coupled with concerns of American exporters about the loss of competitiveness vis-à-vis Europe and Japan, heavily influenced the Nixon administration’s decision to close the “gold window” and end the Bretton Woods era (Odell 1982, Gowa 1983). In the mid-1980s, the trade-related implications of the dollar’s 50% appreciation relative to the German Deutsche Mark and Japanese yen were a major factor leading to the Plaza and Louvre Accords, in which G-7 central banks engaged in coordinated foreign exchange intervention to stabilize their exchange rates (Destler and Henning 1989, Frankel 1994). Most recently, scholars and policymakers have hotly debated whether or not China’s massive trade surplus with the United States is the result of the Chinese government’s active intervention in foreign exchange markets to prevent any significant appreciation of its currency, the renminbi (Bergsten 2006).1 Yet while the trade implications of exchange rates are widely acknowledged, the empirical political economy literature offers surprisingly few tests of the relationship between countries’ trade and exchange rate policies. Economists have focused, instead, largely on the

1

See Ronald I. McKinnon, “Currency Manipulator?” The Wall Street Journal, 24 April 2006; and Charles E. Schumer and Lindsey O. Graham, “Will It Take a Tariff to Free the Yuan?” New York Times, 8 June 2005.

3

effect of exchange rate regime choice on the level and volatility of trade flows (Rose 2000, Levy-Yeyati 2003, Lopez-Cordova et. al. 2003, Klein 2005, Klein and Shambaugh 2006/9). Within IPE, two strands of research have dominated the literature in recent years. The first emphasizes the effects of domestic interests and political institutions on exchange rate regime choice (Frieden 1991/2002, Hefeker 1997, Bernhard and Leblang 1999, Broz 2002, Bearce 2003, Bearce and Hallerberg 2006, Walter 2008). In this view, countries’ exchange rate regime choices depend on the size and trade orientation of different interest groups in the economy (e.g., competitive exporters, non-tradables producers), as well as the structure of electoral, legislative, and bureaucratic political institutions. The second focuses on the use of fixed exchange rates as a solution to the time inconsistency problem confronting monetary policymakers (Bernhard et. al. 2002, Hallerberg 2002, Keefer and Stasavage 2003, Guisinger and Singer 2010).2 From this perspective, the choice of exchange rate regime depends on a government’s incentives to tie its hands and import anti-inflationary credibility by pegging to a low-inflation currency. To date, however, IPE scholars have largely overlooked the potential effects of international trade agreements on national exchange rate policies. In this paper, we seek to address this gap in the literature by focusing on the degree to which membership in preferential trade agreements (PTAs) influences a country’s choice of exchange rate regime. We argue that countries are less likely to adopt a fixed exchange rate (both de jure and de facto) when they have signed a PTA with their “base” country – the country most likely to be their anchor currency based on current and past experiences with fixed exchange rates, regional proximity, and trade ties (Klein and Shambaugh 2006).3 This relationship between a more flexible exchange rate and a PTA with one’s base country exists for two reasons. First, and most 2 3

See Frieden and Broz 2006 for an overview of this extensive literature. We discuss the identification of individual base countries in greater detail below.

4

directly, a PTA with the base country constraints a government’s ability to utilize trade protection to improve domestic producers’ international competitiveness, thereby increasing its incentives to engage in exchange rate protection,” the use of exchange rate policies as a lever to influence the terms of trade and enhance domestic producers’ competitiveness in global markets (Corden 1982). Second, and more broadly, tying one’s hands one trade policy raises the overall costs for a government of further constraining its economic policy autonomy. Thus, even if a government does not seek to actively manipulate the exchange rate for protectionist purposes, it may still be reluctant to relinquish its monetary and fiscal autonomy if it has already made a firm bilateral commitment to free trade with its key economic partner. The remainder of this paper proceeds as follows. First, we discuss the existing literature linking international trade and exchange rate policies. We then develop a set of hypotheses about the relationship between PTA commitments and exchange rate policy choice, which we subject to empirical testing in the third section of the paper using an original dataset of up to 101 countries from 1975-2004. We conclude by offering some thoughts on the ways in which future research might enhance our understanding of the complex relationship between trade and exchange rate policies in the contemporary world economy. More broadly, we discuss the implications of our findings for our understanding of international economic cooperation. In particular, we note that our findings cast doubt on the credibility of international agreements when close policy substitutes exist at the domestic level, or when governments’ commitments in one issue area make them less willing to sacrifice policy autonomy in related domains.

5

Preferential trade agreements and exchange rate regime choice The proliferation of preferential trade agreements (PTAs) is one of the defining characteristics of the contemporary world economy.4 PTAs are a broad class of international commercial agreements that include common markets, customs unions, and free trade areas. While nearly every country in the world now participates in at least one PTA, there is substantial cross-national variation, with some countries belonging to dozens of agreements, while others belong to only one or two (Mansfield, Milner, and Pevehouse 2007). Although they often contain explicit provisions allowing certain types of trade protection (for example, on a particular class of goods), PTAs generally commit member-states to more extensive free trade. Thus, international trade agreements restrict government’s ability to use trade policy (tariffs, NTBs, and other measures) to alter the terms of trade. Moreover, most PTAs contain institutional mechanisms of various types (e.g., dispute settlement mechanisms or arbitration procedures) to ensure that parties to the agreement do not overtly engage in trade policy behavior that undermines the agreement (see Smith 2000). How do PTAs influence a country’s exchange rate policy choices? The answer to this question is not immediately obvious, since PTAs present governments with countervailing incentives. On the one hand, PTAs are “trade enhancing” (Krueger 1999): their express purpose is to lower barriers between countries, thereby increasing trade and exchange across international borders. Given that reducing currency risk in order to facilitate international trade and exchange is the one of the primary economic rationales for adopting a currency peg (Mundell 1961, McKinnon 1962, Kenen 1969), trade openness (and, by extension, PTAs) and fixed exchange rates are generally viewed as complementary. From this perspective, the greater volatility and 4

On the wave of new regional economic integration and PTAs, see Mansfield and Milner 1999, and Vayrynen 2003.

6

greater uncertainty about the level of the exchange rate under a floating regime directly undermines the goals of trade creation underlying a country’s membership in PTAs. All else equal, governments that have pursued trade liberalization through membership in PTAs should, therefore, be more likely to adopt a fixed exchange rate regime as a complement to their international commitments to trade openness. On the other hand, PTAs are also “trade protecting”: they increase international competition and frequently intensify demands for compensation from domestic producers now facing greater import competition. This heightened concern about international competitiveness also places a premium on domestic producers’ concerns about the level of the exchange rate, rather than simply its volatility. As a result, governments that have tied their hands on trade policy through PTA commitments may face stronger domestic pressure to pursue a devaluation or depreciation. Since a 10% real depreciation is equivalent to both a 10% import tax and a 10% export subsidy (McKinnon and Fung 1993), such exchange rate policies amount to “exchange rate protection” – the manipulation of the exchange rate as a substitute for trade policies (e.g., tariffs, quotas, non-tariff barriers) that are prohibited under the terms of government’s PTA commitments (Corden 1982). Given the robust empirical evidence in the literature that more flexible exchange rate regimes are strongly associated with both nominal and real depreciation over the last three decades (IMF 1997, 89; Frieden 2002, 833; Blomberg et. al. 2005), this logic of exchange rate protection implies a correlation between PTA membership and more flexible exchange rate regimes.5

5

Alternatively, governments seeking to engage in exchange rate protection as a substitute for trade protection may still choose to fix the exchange rate but do so at an undervalued level (as in the case of China today) in order to enhance exporters’ competitiveness in global markets. We test for this alternative policy choice in our robustness checks below.

7

Thus, while the “trade enhancing” logic of trade enhancement suggests that PTA commitments should enhance a government’s commitment to a fixed exchange rate, the “trade protection” view points toward a correlation between PTAs and more flexible exchange rate regime choices. Moreover, even if a government that has tied its hands on trade policy through PTA commitments does not face direct pressure from societal interests to engage in exchange rate protection, it may simply be less willing to sacrifice further economic policy autonomy by fixing the exchange rate. As articulated in the Mundell-Fleming model, the workhorse framework for analyzing the political economy of exchange rates (Mundell 1960, Fleming 1962), countries can achieve only two of three policy goals simultaneously: a fixed exchange rate, full capital mobility, and domestic monetary autonomy – the ability to adjust interest rates in reaction to exogenous shocks or domestic economic downturns. Given the substantial degree of international capital mobility in the contemporary world economy, this logic implies that governments choosing to adopt a fixed exchange rate must sacrifice monetary policy autonomy. Moreover, while fixed exchange rates increase the short-run efficacy of fiscal policy when capital is mobile (Clark and Hallerberg 2000, Hallerberg 2002), persistent balance of payments deficits undermine the long-term credibility of a currency peg. Therefore, adherence to a fixed exchange also imposes constraints on a government’s fiscal autonomy. Governments that have already sacrificed autonomy over trade policy by signing one or more PTAs may, therefore, be less willing to accept these additional constraints on their economic policy autonomy. In short, while trade openness and fixed exchange rates are traditionally thought of as complements, the constraints that PTAs place on a government’s ability to utilize trade policy create countervailing incentives to choose a more flexible exchange rate regime, either for reasons of exchange rate protection or simply to retain monetary and fiscal policy autonomy

8

once the government has tied its hands on trade policy. These incentives to opt for monetary autonomy and flexible exchange rates are most acute when the PTA in question is with the “base” country, the country to which a government has chosen to fix its exchange rate. In such cases, a depreciation or competitive devaluation directly substitutes for the government’s inability to employ trade protection. Indeed, exchange rate regime choice in the contemporary global economy is inherently bilateral: the decision to fix or float the currency is taken with respect to a specific base country (Klein and Shambaugh 2009).6 Although there is some evidence that multilateral volatility is greater under more flexible exchange rate regimes, the primary effects of exchange rate regime choice on currency stability and volatility occur bilaterally (Ghosh et. al. 2002, Husain et. al. 2005, Klein and Shambaugh 2009). By extension, the impact of a PTA on exchange rate regime choice should be most pronounced when the agreement constraints a government’s ability to use trade policy vis-à-vis its monetary base country. In contrast, floating or devaluing the exchange rate against the base country has only indirect effects (or, potentially, none at all) on the terms of trade with a country’s non-base PTA partners. In other words, while exchange rate policy may be a close substitute for trade policy within a country-base dyad, it does not necessarily allow governments to alter the terms of trade with their other PTA partners. For this reason, we expect the relationship between PTA commitments and exchange rate regime choice to be most pronounced when a country’s PTA partner is also its monetary base country. Furthermore, in these cases, we expect the incentives to engage in exchange rate protection and/or to retain monetary and fiscal policy autonomy to “trump” the incentives to

6

There are a handful of countries that peg to a basket of currencies (e.g., Kuwait), but the vast majority of countries peg to a single currency.

9

reduce volatility through the adoption of a currency peg. Thus, our primary hypothesis is as follows:

•

All else equal, countries that have “tied hands” on trade policy by signing a PTA with their monetary “base” country will be less likely to adopt a fixed exchange rate.

Similarly, we also expect to observe a correlation between a PTA with the monetary base country and changes in exchange rate regime choice:

•

All else equal, countries that have signed a PTA with their monetary “base” country will be more likely to move toward a more flexible exchange rate regime.

Finally, since hand-tying on trade policy by entering a PTA with the monetary base country also intensifies concerns about the level of the exchange rate, we expect to find a correlation between “base PTAs” and the real exchange rate level, regardless of whether a government chooses to fix or float its currency:

•

All else equal, countries that have signed a PTA with their monetary “base” country will have a more depreciated currency.

In sum, we expect that PTA commitments within country-monetary base dyads will be associated with both the adoption (and shift to) flexible exchange rate regimes and a more depreciated currency, as governments seek to offset “hand-tying” on trade policy by retaining greater monetary and fiscal autonomy and/or actively engaging in exchange rate protection. We want to emphasize, however, that this effect of base PTAs on exchange rate policy choice is conceptually separate from the general tendency for countries to fix the exchange rate when they more heavily dependent on trade with the base country. Indeed, we fully expect that the overall

10

probability of fixing the exchange rate will be higher countries for whom trade with the monetary base country constitutes a larger share of total trade. Thus, while we expect to find a negative relationship between base PTAs and our dependent variables, this effect may be offset in cases where a country is extremely dependent on trade with the base country. In short, the net effect of these factors on both exchange rate regime choice and the level of the exchange rate is likely to be highly case-specific. Finally, we note that our argument makes no concrete predictions about the relationship between “non-base” PTAs and governments’ exchange rate policy choices. As noted above, the indirect effect of exchange rate policies on competitiveness with non-base countries is less clear, since the impact of floating or depreciating against the base country does not always translate into corresponding changes in the bilateral exchange rate with non-base states. Therefore, our prior is that more extensive non-base PTA ties will reinforce the complementarity between fixed exchange rates and trade agreements, as the benefits of reduced currency risk and volatility outweigh the less certain benefits of exchange rate protection and enhanced policy autonomy. Our primary concern here, however, is with testing the direct effects of PTAs within the countrybase dyad on exchange rate policies, whether or not these “third party” effects are present.

Empirical analysis In order to test the extent and direction of this relationship between international trade agreements and exchange rate policies, we employ time-series/cross-sectional analysis of data of an original dataset covering 101 countries from 1975 to 2004. Our unit of analysis is the country-year. We employ the following model to investigate the determinants of a country’s exchange rate regime policy choices:

11

ERPOLICYi,t = β0 + β1 PTA Basei,t-1 + β2Trade Basei,t-1 + β3# PTAi,t-1+ β4PTA Coveragei, t-1 + β5Trade/GDPi, t-1 + β6Ag Exportsi, t-1 + β7Mfg Exportsi, t-1 + β8GDPi,t-1 + β9pcGDPi,t-1 + β10Inflationi,t-1 +β11Capital Openi, t-1 + β12Regime Typei,t-1 + β13IFI/GDPi,t-1 + β14EEC/EUi,t-1 + β15ERPOLICYi,t-1 + εi,t

Dependent variables Our primary dependent variable is a country’s choice of exchange rate regime. Until recently, empirical analyses of countries’ exchange rate regime choices drew primarily on selfreported data provided to the IMF by its member-states about their exchange rate regime choices. In recent years, however, a number of scholars have highlighted the frequent discrepancies between governments’ public statements about their official exchange rate policies (i.e., de jure regime choice) and their actual behavior (de facto regime choice). These new de facto measures of exchange rate behavior have rapidly become the state-of-the-art in empirical work on the political economy of exchange rates, since they more accurately capture governments’ “deeds” rather than simply their “words.” A number of different de facto exchange rate regime classifications are now in use (Levy-Yeyati and Sturzenegger (LYS) 2003, Reinhart and Rogoff (RR) 2004, Klein and Shambaugh (KS) 2006). Each differs in its methodology and yields quite different classifications across countries and over time. In our analysis, we primarily employ the classification developed by Reinhart and Rogoff (2004), who utilize deviations from official announcements, data on parallel (black market) and official dual exchange rates, reserve movements, and detailed country chronologies to code de facto exchange rate regimes from 1970-2007. Using this data, RR create a 15-point scale of exchange rate regimes, which they

12

then aggregate into a coarse 5-point scale (fixed, narrow crawling peg/band, wide band/managed floating, freely floating, freely falling). The classification is based on the conditional probability that the exchange rate stays within a given range over a rolling five-year window. Thus, RR’s index allows for a degree of depreciation/devaluation and monthly volatility within the same classification of exchange rate regimes. At the same time, in contrast to LYS, the RR coding more accurately characterizes clear policy changes in the exchange rate regime. The cost of this coding, of course, is that the bar for regime changes is higher: indeed, countries are not deemed to have changed their regime if they have fixed exchange rates but experience a one-time devaluation, or if they are floating but do not experience any market volatility in a given year. For the purposes of our analysis, however, this higher bar is an advantage, since we are primarily interested in the question of whether membership in PTAs leads to purposeful changes in countries’ exchange rate regime choices (rather than whether international trade commitments affect exchange rate volatility per se). In the analysis that follows, we employ the RR de facto classification as our primary dependent variable, with slight modifications based on recent work in the literature (e.g., Guisinger and Singer 2010).7 Specifically, we exclude observations from the RR dataset in

7

Data are available at http://terpconnect.umd.edu/~creinhar/Data/ERA-Annual%20coarse%20class.xls. We also, as discussed further below, use the KS classification in robustness checks, given its advantages in classifying peg “spells”. In our view, both the RR and KS classifications are more suitable for our analysis than the third index provided by Levy-Yeyati and Sturzenegger (LYS) (2001, 2005, 2007). This alternative de facto classification relies on clustering country-year observations on the basis of three variables: nominal exchange rate movements during a year, movements in central bank reserves, and changes in the rate of change of the exchange rate. One advantage of this methodology over the KS classification is its use of reserves, which captures foreign exchange market interventions by the central bank. A key disadvantage of the LYS index, however, is that cluster analysis classifies many countrycases with an unvarying exchange rate, no reserves volatility, and/or missing reserves data as “ad hoc” fixes, even though these cases do not necessarily indicate that a government or central bank is actively working to maintain a de facto currency peg. Another disadvantage is that the LYS index does not treat years with discrete devaluations from one fixed rate to another as “pegs.” As a result, it classifies countries that generally peg but experience one-time devaluations as “floats,” even if these countries

13

which the exchange rate regime is classified as “freely falling,” as well as those in which the dual market exchange rate data is missing. In addition, we exclude cases in which a country is experiencing hyperinflation (annual inflation greater than 150%).8 Finally, we also exclude countries whose average population in the sample period is less than 400,000, in order to ensure that our results are not biased by the policies of extremely small (primarily island) economies that tend to more frequently adopt “hard” fixed exchange rates than other states.9 As our measure of de jure exchange rate regime choices, we draw on the IMF’s 4-point official classification as presented in the Fund’s Annual Report on Exchange Rate Arrangements.10 In addition to the basic indices of de facto and de jure regime choice, we calculate two further variables intended to capture changes over time in countries’ exchange rate regime choices. First, using the original 4-point RR classification, we create ∆RR, the year-to-year change in a country’s de facto exchange rate regime, based on the Reinhart and Rogoff scale. This variable is intended to capture shifts by countries toward flexible exchange rates over time. Second, we calculate ∆DJ, the year-to-year change in a country’s de jure exchange rate regime, based on the IMF’s official classification. Finally, in addition to measuring exchange rate regime choices and changes in these choices over time, we also measure the level of the exchange rate by coding the natural log of a country’s real effective exchange rate (REER), as well as the three-year moving average of the REER. These variables are taken from the IMF’s

consistently maintain a peg both before and after the devaluation episode. Thus, the LYS classification introduces substantial ambiguity about the precise definition of de facto “fixes” and “floats.” 8 The results presented below are substantively identical if we include the freely failing observations in the sample. RR themselves code cases in which monthly inflation exceeds 40% as “freely falling.” However, this leaves some cases of annualized hyperinflation in the dataset. To rectify this, we exclude country-cases in which annualized inflation equals or exceeds 150%. 9 Iceland and Luxembourg are the two exceptions to this rule. Once again, the substantive results below are unaffected by this data selection strategy. 10 We utilize the data file available on Carmen Reinhart’s website: http://terpconnect.umd.edu/~creinhar/Data/ERA-IMF%20class.xls.

14

trade-weighted real effective exchange rate index, which is available through the World Bank’s World Development Indicators. The index is scaled such that the value of the real effective exchange rate in 2000 for each country equals 100.11 While changes in REER are less explicitly an indicator of active policy choice than the regime variables outlined above, movements in this variable may capture “Chinese-style” exchange rate protection, in which the government pegs the currency at an undervalued rate, rather than floating the currency in pursuit of a depreciation or competitive devaluation. In addition, a persistently undervalued exchange rate indicates that a government is pursuing economic policies designed to enhance international competitiveness, regardless of its de facto or de jure exchange rate regime choices.

Independent variables In order to evaluate our hypothesis linking PTA commitments to exchange rate policies, we introduce four key independent variables.12 First, we code a variable, PTA Base, for whether state i has a PTA with its base country. We use Klein and Shambaugh’s definition of a base country to generate this and all subsequent variables relevant to base-country status.13 Note that Klein and Shambaugh code base countries even for those states that do not historically fix their

11

We drop 34 severe outlier observations (i.e., those exceeding 3 standard deviations above or below the mean) and use the natural log of the REER in order to account for the highly-skewed distribution of the data. 12 All independent variables are measured in t – 1 to lessen concerns about endogeneity. 13 As described by Klein and Shambaugh (2006): “The base country is determined through the pegging history of a given country as well as through tests against a variety of countries, the declared intent of the country, and readings of various currency histories. For the purpose of comparative bilateral volatility tests, we need a “base” country for countries when they have a floating exchange rate. In these cases, the base is the country to which the country with the floating exchange rate pegged in the past, or a major industrial country with which it has a prominent economic relationship (for details see Shambaugh 2004).”

15

currencies.14 For data on PTAs, we use updated data from Mansfield, Milner, and Pevehouse (2007). Thus, this variable takes on a value of 1 if the state in question is currently in any type of reciprocal preferential trading arrangement with their base country.15 If our hypothesis is correct, we should see the hand-tying effect revealed here: the presence of a PTA with a base country should lead to a decline in the probability of a country adopting a fixed exchange rate, an increase in the probability of shifting to a more flexible regime, and a more depreciated level of the real exchange rate. As noted above, however, this PTA effect is separate from a country’s overall trade dependence on its base country. Therefore, we include a separate variable, Trade Base, which is the proportion of state i’s trade that takes place with the base state (regardless of whether a PTA exists).16 In general, we expect this variable to be associated with more fixed exchange rate regimes and less depreciation: as trade increases with the current (or potential) peg country, a government will be more likely to pursue exchange rate stability in order to credibly commit to a stable trade environment. In short, the predicted effects of PTA Base and Trade Base on exchange rate policies point in opposite directions. Finally, as a test to see if general PTA involvement (with any state) is more likely to influence the choice of exchange rate regime, we introduce # PTA, which counts the number of reciprocal PTAs with which state i is a member of in year t - 1. We introduce Non- base PTA Coverage, which is the percentage of trade for state i “covered” by PTAs with all countries except the monetary base state. To compute this variable, we subtract trade conducted with the

14

Following Klein and Shambaugh, we exclude the US from our sample, thus eliminating the one country that has no natural base state to which to peg. 15 We exclude non-reciprocal PTAs in our analysis, as they do not constrain a country’s trade policy in the same way as reciprocal agreements. As a result, the concerns about retaining policy autonomy and engaging in exchange rate protection outlined above are unlikely to obtain in these cases. 16 Trade data is taken from Keshk, Barbieri, and Pollins 2009.

16

base country (i.e., the value of Trade Base) from the total value of trade conducted with state i’s PTA partners.17 Thus, this variable will determine if PTAs with major trading partners serve to influence exchange rate policy choice outside those agreements signed with a base country.

Control variables In addition to including controls for international trade commitments, we also include a series of variables that control for alternative economic and political determinants of exchange rate policy choices. These variables are drawn from the existing literature on the political economy of exchange rates (Frieden and Broz 2001/2006). First, to ensure that our PTA variables are not simply measuring the general trade dependence of a particular country, we introduce Trade Open, which is the natural logarithm of state i's trade (imports + exports) to GDP ratio in year t-1. The standard prediction in the literature suggests that more tradedependent economies are likely to prefer fixed, stable exchange rates. If Base Trade or PTA Coverage proxies for a country’s overall trade dependence, it could capture this general story rather than one involving trade institutions. In a similar vein, it is likely that trade-dependent economies will join PTAs to lock-in trading relationships with key partners. Thus, it is crucial to include this measure to hedge against omitted variable bias. The data are taken from the World Bank's World Development Indicators. Second, we control for the influence of organized domestic interests on a government’s exchange rate policy choice (Frieden 1991/2002, Hefeker 1997). In particular, we include two measures of the sectoral composition of a country’s exports, as proxies for the degree to which societal interest groups are sensitive to both the level and volatility of the exchange rate. While 17

We assume that all trade within a dyad is covered by the PTA. In reality, there are often exceptions for some goods, but given a lack of data on these exceptions, we cannot accurately compute the true coverage variable.

17

overall trade openness (e.g., trade/GDP) provides a rough measure of a country’s (and its exporters’) preference for reducing currency volatility, certain types of exporters are more sensitive to the level of the exchange rate than others. In particular, exporters whose prices respond rapidly to changes in currency values – that is, where “pass-through” of exchange rate movements from foreign producers to local consumers in the form of price increases/decreases is high – are more sensitive to the level of the currency relative to its volatility (Frieden and Broz 2006, Valderrama 2004, Olivei 2002). Generally, pass-through is higher when goods are highly standardized and/or international competition is stronger – for example, in agricultural commodities, textiles, and simple manufacturing (Campa and Goldberg 2002).18 In contrast, pass-through is less of a concern when goods are highly specialized and/or differentiated, such as automobiles, commercial aircraft, and products with strong brand or quality distinction (Frieden, forthcoming). Measuring pass-through and its corresponding effects on exporters’ concerns about the exchange rate level is notoriously difficult, as it depends on factors such as the extent to which firms rely on imported intermediate inputs and the degree to which products are highly differentiated (Frieden, Ghezzi, and Stein 2001; Goldberg and Knetter 1997). Nevertheless, as rough proxies, we follow the existing literature in controlling for both the percentage of all exports that originate in the manufacturing sector, labeled Mfg Exports, as well as the percentage of exports that are from the agriculture or raw materials sector, labeled Ag Exports (Frieden 2002; Frieden, Ghezzi, and Stein 2001). Both variables are taken form the World Bank’s World Development Indicators. Although these compositional measures of exports are admittedly imperfect measures of concerns about pass-through and the level of the exchange rate, 18

Consequently, manufacturers in less developed countries tend to be more focused on the level of the exchange rate than those in advanced economies (Frieden, Ghezzi, and Stein 2001).

18

manufactured goods are generally less susceptible to pass-through than commodities and agricultural products. All else equal, we therefore expect countries whose exports consist of a larger share of manufactured goods to be relatively less concerned with the level of the exchange rate (and therefore, relatively more concerned with minimizing currency volatility). Consequently, higher shares of manufactured exports should be associated with an increased probability of adopting a fixed exchange rate. The reverse argument then holds for the level of agricultural exports. We expect countries more reliant on agriculture and raw materials to be relatively more concerned with the level of exchange rate, and thus be less likely to fix the exchange rate and more likely to shift toward a more flexible regime. At the same time, both manufactured and commodity exporters should have preferences for a more depreciated currency, as this enhances their competitiveness in global markets. All else equal, we therefore expect countries with larger shares of total exports in these sectors to have more depreciated currencies, as measured by the level of the real exchange rate. Next, we also include a battery of macroeconomic controls commonly associated with exchange rate regime choice. First, we include controls for the size and level of development of the economy of each state in our sample. GDP is the natural log of gross domestic product of state i. Traditionally, larger economies are more likely to choose monetary policy autonomy since their own domestic markets are so important. Indeed, with the exception of the European Monetary Union, most larger economies in the post-Bretton Woods era have chosen floating exchange rates.19 Second, we control for level of development by measuring each state's per capita GDP (pcGDP), in order to control for the general expectation that advanced economies are more likely to adopt floating exchange rates than developing countries. Indeed, since developing countries are generally more susceptible to currency crises (Caprio and Klingebiel 19

Moreover, the Euro itself floats against other currencies.

19

2003), they generally place a greater premium on reducing currency volatility than developed countries.20 Moreover, since most developing countries are subject to “original sin” (Eichengreen and Hausmann 1999) – an inability to borrow internationally in their own currency – depreciation or devaluation has the negative side effect of increasing a country’s external debt obligations. As with GDP, pcGDP also enters the model as a natural log. Both sets of data are taken from the World Bank’s World Development Indicators.21 Third, we include a variable to measure inflation levels in state i (Inflation), since higher inflation in an economy may pressure a government to peg its currency as a nominal anchor for monetary policy (Frieden and Broz 2001). This variable is taken from the World Bank’s World Development Indicators, with missing data filled in using the IMF’s International Financial Statistics. The variable enters into the regression as a natural log. We also include two variables measuring a country’s level of international financial integration, in order to account for the capital mobility dimension of the Mundell-Fleming trilemma, as well as the fact that the justification for PTA membership is often to lure foreign direct investment (Milner and Buthe 2008). The first variable, Capital Open, is a policy measure of financial openness: the Chinn-Ito index measuring the extent to which a country employs capital controls (Chinn and Ito 2006). The index, which is drawn from the IMF’s official data, measures four facets of capital account openness: the existence of multiple exchange rates; restrictions on current account transactions; restrictions on capital account transactions; and requirement of the surrender of export proceeds. Capital Open, therefore, accounts for variation

20

Calvo and Reinhart refer to this as “fear of floating” (2000). The underlying logic is that fears of speculative attacks and/or large depreciations makes developing country governments unwilling to pursue floating exchange rates. Calvo and Reinhart find that even those developing countries that nominally float their currencies often heavily intervene in foreign exchange market to prevent large movement in de facto exchange rates. 21 GDP and pcGDP are in constant 2000 dollars.

20

in government policies regulating the cross-border movement of capital. The second variable, IFI/GDP, measures instead the actual level of international financial integration (foreign assets + foreign liabilities as a percentage of GDP). Data are taken from the External Wealth of Nations Mark II dataset (Lane and Milesi-Ferreti 2007). We do not have strong theoretical priors on the signs of these variables, given that the Mundell-Fleming framework makes no clear predictions about which two sides of the trilemma (capital mobility, fixed exchange rates, monetary autonomy) countries will choose. That said, past empirical studies generally have found a positive correlation between capital account openness and higher levels of international financial exposure and the adoption of fixed exchange rates, particularly in developing countries. Finally, we add two additional controls for political institutions. The first controls for the influence of domestic political institutions on exchange rate policy choices. Many scholars have noted the relationship between democracy and various types of democratic institutions with exchange rate regime choices (e.g., Bernhard and Leblang 1999; Hallerberg 2002). Moreover, other scholars have noted the correlation between regime type and membership in PTAs (Mansfield, Milner, and Rosendorff 2002). To this end, we include Regime Type which is the Polity score of state i in year t-1, although we do not have strong priors on its signs in the regressions given the mixed evidence in the existing empirical literature.22 The second political control accounts for membership in the European Economic Community/European Union (EEC/EU). The variable is coded 1 if state i is a member of the EU or its predecessor organizations. We include this “EU dummy” for two reasons. First, we need to control for the fact that the EU member-states tend to have a disproportionately high PTA coverage, in terms of the share of overall trade, the number of agreements, and the frequency with which they have a 22

We use the traditional -10 to +10 polity scale. Data are taken from Gleditsch’s (2008) recoded Polity data.

21

“base” PTA.23 Second, we need to also control for the extensive degree of monetary and exchange rate cooperation throughout the period in our data sample in the decades prior to the adoption of the euro.24 The final variable in each of our models is a lagged endogenous variable to control for the fact that exchange rate policy is high autoregressive – both regime choices and real exchange rate levels tend to be sticky and this variable will control for those temporal dynamics.

Results PTAs and exchange rate regime choice For our models of both exchange rate regime choice and changes in regime, we utilize ordered probit models to test our hypotheses, given the ordinal, categorical nature of our data on de facto and de jure exchange rate regimes. This approach avoids the need to draw arbitrary distinctions about what is a “fix” or “float” and takes full advantage of the information provided in the various regime classifications about more fine-grained changes in regime choice over time.25 Table 1, columns 1 through 2 presents the estimates of the models with the two different measures of exchange rate regime choice outlined above. Column 1 estimates the determinants of a country’s de facto choice of exchange rate regime, based on the Reinhart-Rogoff 23

Indeed, since Germany is the base country for nearly all EU member-states in the entire sample (the exceptions are Ireland before 1978 (UK as base) and Germany itself (US as base), Base PTA equals 1 for nearly all of these country-year observations. 24 It is important to note that the results presented below are substantively identical if we exclude the EU countries, thereby alleviating our fears that our findings are dependent solely on this sample. In addition, we also note that the EMU countries are excluded from the sample, along with all other countries in a currency union, in order to focus only on those states for whom changes in the exchange rate regime are a feasible choice. 25 As robustness checks, however, we have replicated our models using dichotomous codings of exchange rate regime, in which the 4-point RR and IMF scales are classified into broad “fix” and “float” categories. This approach also allows us to incorporate country-specific fixed effects into the analysis. For the sake of space, these results are not shown here, although our results are substantively identical in these alternative models. Results available on request.

22

classification, while Column 2 estimates what factors shape a country’s de jure exchange rate regime, using the IMF’s official classification.26 PTA Base is negative and statistically significant in both models, which suggests support for our hypothesis: those countries with a PTA with their base country are more likely to adopt more flexible exchange rate regimes, both de jure and de facto. Examining Trade Base, however, the conventional logic of credible commitments and trade seems clear: higher levels of trade with the base country (irrespective of the presence of a PTA), leads to more fixity in exchange rate regime choice. Figure 1 plots the predicted probabilities of moving from a “2” (1% band) to a “3” (managed float) in the Reinhart-Rogoff de facto measure.27 As trade with the base country rises, the propensity to move to managed floating arrangements declines by about 40 percent either with or without PTA membership with the base country. And while this variable is statistically significant for our de facto measures, it does not achieve statistical significance in the de jure measures. In no model does # PTA achieve statistical significance, suggesting that outside of preferential arrangements with real or potential base countries, PTAs do not influence exchange rate regime choice. Yet, PTA Coverage is negative and statistically significant for the de jure estimates found in column 2. This suggests that, at least for the declared exchange rate policy, increased trade within a PTA (independent of the trade-PTA coverage with the base country)

26

In our models, we exclude certain country-years. We exclude the US since it is the most frequent “target” of a peg. We also exclude members of currency unions, since those arrangements encompass both PTAs and permanently fixed exchange rates. Finally, we exclude countries experiencing hyperinflation (annualized inflation greater than 150%) since these countries are highly likely to peg to stabilize their economies, independent of any other political or economic factors. Adding any of these observations to the estimation sample does not have any meaningful impact on our estimates, however. 27 This is commonly viewed as the “cut point” in the literature between “fixed” and “floating” regimes in studies where exchange rate regime choice is coded as a binary outcome.

23

encourages fixing. Once again, this is in line with traditional expectations about the relationship between trade and fixed exchange rates. Moving to the estimates of the control variables, only the estimate of GDP is statistically significant across both models and possesses the same sign – as expected, larger countries are associated with an increased propensity to float a currency. Inflation, interestingly, is statistically significant in both models, yet is negative in the case of de facto exchange rate measurements and positive in the case of de jure exchange rate measurements. This result suggests that countries experiencing high inflation are more likely to officially adopt fixed exchange rates but find these difficult to maintain in practice when inflation differentials with the monetary base country exist. Finally, several variables achieve statistical significance in the de jure model, many pointing towards an increasing likelihood of floating: more openness to capital, higher international financial integration, and more highly democratic states are all prone to move away from a fixed regime choice. Higher trade dependence, as predicted, works in the opposite direction: as dependence on trade increases, the propensity to fix grows.

PTAs and changes in the exchange rate regime In sum, the results from columns 1 and 2 provide strong support for our hypothesis that PTA commitments with one’s monetary base country reduce the willingness of governments to adopt fixed exchange rates. To further probe this hypothesis, we estimate two additional models, which look at the year-to-year change in both de jure and de facto measures of exchange rate regime choice. These models are identical to our original model with two exceptions: the dependent variable measures the year-over-year change in exchange rate regime, and we add an additional variable which controls for the previous year’s change in the exchange rate regime.

24

The estimates of these new models (found in columns 3 and 4 of Table 1) are highly consistent with our previous estimates. PTA Base continues to be positive and statistically significant, suggesting PTAs with base countries increase the probability that a government will shift toward a more flexible exchange rate policies. This is true for both the measure of de facto and de jure exchange rate policy. Also consistent with the previous models, the estimate of Trade Base is negative and statistically significant for the de facto measurement of exchange rate policy. Again, this supports the accepted logic that states which are heavily dependent on trade with a real or potential monetary base country are more likely to opt for less flexible exchange rates regardless of their PTA status with that state. As in the previous models, # PTA continues to be statistically insignificant while PTA Coverage is now statistically significant for both dependent variables. As trade with non-PTA partners increases, the probability of shifting to a more fixed exchange rate increases. Again, this confirms previous hypotheses concerning the importance of fixed exchange rates for economies reliant on international trade. Likewise, the estimates of the control variables are virtually identical, but with one exception. Trade/GDP is now negative and statistically significant for the de facto measure of exchange rate policy. The estimate of this variable is now consistent across both dependent variables. Otherwise, all estimates (including the mixed signs on Inflation) remain the same. In sum, there is strong evidence across these four models of the effects of PTA commitments with monetary base countries on exchange rate regime choice. PTAs signed with a currency base country push states toward more flexible exchange rates, even as trade rises with the base state and overall PTA trade coverage increases. Yet, the estimates of these other two variables, Trade Base and PTA Coverage, suggest that the received wisdom that trade-dependent

25

states prefer fixed exchange rates is also broadly supported by the data. Figure 1 illustrates these separate and opposite effects: while increasing trade with a base country lowers the propensity to adopt flexible exchange rates for all countries, the overall probability of shifting toward a more flexible regime is higher for states who maintain a PTA with their base country.

PTAs and the duration of peg spells As a final check on the robustness of our results, we turn to a different measure of exchange rate policy coded by Klein and Shambaugh (2006), which more accurately measures the duration of a peg “spell” – the number of consecutive years in which a country has maintained a fixed exchange rate.28 Our model is thus a Cox proportional hazard model that estimates the influence of our covariates on the hazard rate that a country will end its spell of fixing the exchange rate. For these models, positive coefficients suggest a more rapid end to a peg spell, while negative estimates suggest longer spells of exchange rate pegs. Other than the new dependent variable and new estimation technique, the specification of the model is the same as discussed earlier. The results of this new approach can be found in column 5 of Table 1. These estimates 28

The Klein and Shambaugh (KS) classification is similar to that used by Shambaugh (2004). It presents a binary coding in which a country is deemed to have a “fixed” exchange rate in a given calendar year, with its currency pegged to the currency of a base country, if its month-end official bilateral exchange rate stays within a +/- 2% band during each month of the year, as well as over the course of that year. Since the coding is annual, the peg must last for at least a full calendar year for a country to be classified as pegged for that year; pegs that last less than a full year are classified as non-peg (“floating”) regimes. The primary advantage of the KS regime is that its definition of a peg is clear, invariant over time, and in line with historical definitions of fixed exchange rates as used during the gold standard era and during Bretton Woods and the European Monetary System (EMS). An important disadvantage of this classification, however, is that focus on calendar year peg spells risks missing the “forest for the trees”: it might be the case that a country experiences temporary breaks in its peg spells (i.e., single-month gaps within a year) that result in a coding of “floating” for the year, even if it maintains its commitment to a fixed exchange rate over the longer term. KS treat these cases as “floats,” even though they may not be indicative of purposeful changes in a government’s exchange rate regime policy. For this reason, we believe the RR classification is preferable as an overall measure of de facto exchange rate regime choice. However, we use the KS classification here as a better measure of peg spell duration.

26

turn out to be highly similar to our previous models, thereby reinforcing our confidence in the earlier findings. The estimate of PTA Base is positive, suggesting that PTAs with base countries increase the probability that a government will drop its fixed exchange rate commitment more quickly, either to pursue exchange rate protection or to retain monetary and fiscal autonomy once it has tied its hands on trade policy vis-à-vis the base country. Once again, the estimates of our trade coverage variables point in the opposite direction and also remain statistically significant. Thus, more trade dependent economies (with the base country or with PTA members) are more likely to sustain a currency peg for longer periods of time. The estimates of the control variables are also similar, although many of the control variables do not achieve statistical significance. The estimate of democracy is positive and significant, suggesting that more democratic states leave their pegs more quickly that their authoritarian counterparts. Inflation remains positive, once again illustrating the difficulty that states have in maintaining a fixed exchange rate under inflationary conditions. Finally our measure of agricultural composition of the export economy is negative, indicating that highly agriculturally dependent economies hold their pegs longer. In sum, these results, utilizing a different dependent variable coding scheme and an alternate estimation method, yield highly similar results to our previous efforts.

PTAs and the level of the exchange rate Thus far, our findings offer robust support for our argument that governments are less likely to adopt fixed exchange rates when their hands are tied on trade policy as a result of PTA commitments to their monetary base country. In this final empirical section, we move on to consider the question of whether PTA commitments also affect the level of the exchange rate.

27

As noted above, an alternative method of exchange rate protection is to peg the currency at an undervalued rate, rather than allowing it to float in the hopes of a competitiveness-enhancing depreciation. Such a strategy is at the heart of the ongoing debate about the dollar-renminbi exchange rate and the accusations of US policymakers that China is engaging in currency manipulation (Bergsten 2006). 29 In Table 2, we therefore re-estimate our models using two new dependent variables: the natural log of the trade-weighted real effective exchange rate (REER) for each country-year in our sample, and the log of the three-year moving average of the REER. 30 These variables are intended to measure the degree to which PTA commitments affect the current level of the exchange rate (independent of the choice of regime), as well as the longer-term trend of that level. If a state is seeking to engage in exchange rate protection against its monetary base country, we should observe a negative relationship between PTA base and the REER. For these models, we employ OLS regression with country and year fixed effects, along with robust standard errors clustered on country. In both sets of estimates, PTA Base is significant and negative; the result is both larger and more robustly significant in Model 7, which employs the three-year moving average of the REER. These findings support our argument that free trade commitments with one’s monetary base country create incentives to pursue a more depreciated currency for the purposes of enhancing international competitiveness. Moreover, they suggest that this result is strong and robust over time, rather than an artifact of the REER level in any particular year. Although it is difficult to pinpoint precisely whether such behavior is the result of deliberate government actions to engage in exchange rate protection, these findings nonetheless suggest that countries are indeed more likely to alter their exchange rate 29 30

Ronald I. McKinnon, “Currency Manipulator?” The Wall Street Journal, 24 April 2006. Data on real effective exchange rates are taken from the Bank of International Settlements (2006).

28

policies to enhance international competitiveness when they can no longer use trade policy vis-àvis their monetary base country. Viewed in conjunction with our earlier findings about the choice of exchange rate regime, these results offer further support in favor of our argument and hypotheses.

Conclusions Although scholars of international political economy have long recognized the importance of both the stability and level of the exchange rate for international trade, the literature to date has paid little attention to the relationship between international trade agreements and exchange rate policy choice. In this paper, we seek to address this gap in the literature by focusing on the degree to which membership in preferential trade agreements (PTAs) influences a country’s choice of exchange rate regime. We argue that countries are less likely to adopt a fixed exchange rate (both de jure and de facto) when they have signed a PTA with their “base” country – the country most likely to be their anchor currency based on current and past experiences with fixed exchange rates, regional proximity, and trade ties. Similarly, we argue that countries that have entered base PTAs will, all else equal, have more depreciated currencies, as measured by the level of the real exchange rates. We argue that this relationship between the flexibility and level of the exchange and a PTA with one’s base country exists for two reasons. First, and most directly, a PTA with the base country constraints a government’s ability to utilize trade protection to improve domestic producers’ international competitiveness, thereby increasing its incentives to engage in exchange rate protection, the use of exchange rate policies as a lever to influence the terms of trade and enhance domestic producers’ competitiveness in global markets. Second, and more broadly,

29

tying one’s hands one trade policy raises the overall costs for a government of further constraining its economic policy autonomy. Thus, even if a government does not seek to actively manipulate the exchange rate for protectionist purposes, it may still be reluctant to relinquish its monetary and fiscal autonomy if it has already made a firm bilateral commitment to free trade with its key economic partner. Using an original dataset of up to 101 countries from 1975-2004, we find strong evidence in support of these hypotheses. The results are robust to multiple specifications and estimation techniques, all of which provide consistent results. These findings shed substantial light on the complex relationship between trade and monetary commitments in the contemporary global economy. More broadly, our analysis has important implications for our understanding of international cooperation. Specifically, it suggests that some international agreements may not be the robust credible commitment mechanisms that international relations scholars often assume them to be. Indeed, as our findings suggest, whether international agreements such as PTAs are “ties that bind” depends critically on a government’s other policy options. When alternative domestic policies – such as manipulating the exchange rate – can offset or overturn the domestic consequences of international commitments, international agreements may not achieve their stated goals. In the context of international trade, we might therefore observe de jure free trade (i.e., the reduction of tariffs and non-tariff barriers) in tandem with de facto protection through exchange rate manipulation – an outcome that is unlikely to yield the expected economic benefits of trade liberalization but might be politically advantageous for domestic political reasons.31 While our findings suggest that this type of behavior is common in the realm of international trade, its prevalence in other issues areas remains an empirical puzzle in 31

An important policy implication is that efforts to further trade liberalization through PTAs may have the unintended consequence of creating greater interstate conflict over exchange rate policy.

30

international relations. To the extent that governments do seek to circumvent international commitments through alternative means, however, the logic underlying exchange rate protection sheds light on the compliance problem in international cooperation. In particular, it suggests that governments are less likely to comply with international agreements when they retain domestic autonomy over alternative policies that are close substitutes for the proscribed behavior. In these cases, we are likely to observe high levels of compliance but few meaningful effects on actual outcomes, as countries comply narrowly with the “letter of the law” while violating the spirit of international agreements by pursuing offsetting domestic policy substitutes. Future research that identifies the degree of “substitutability” between alternative government policies might lead to important new insights about the conditions under which international agreements actually have the intended effect on states’ behavior in the contemporary world economy.

31

TABLE 1. ESTIMATES OF THE DETERMINANTS OF EXCHANGE RATE REGIMES, 1975-2004 Model Variable

1 De facto (RR) Ord. Probit PTA Base 0.516*** [0.169] Trade Base -1.052*** [0.353] # PTA 0.001 [0.033] PTA Coverage (Non-base) -1.458 [0.792] Trade/GDP (log %) -0.003 [0.002] Agricultural/material exp -0.008 [0.006] Manufactured exports 0.000 [0.003] GDP (log) 0.105** [0.051] GDP per capita (log) 0.054 [0.078] Inflation (%) -0.210*** [0.042] Capital Open 0.004 [0.040] IFI/GDP (log %) -0.041 [0.099] POLITY score 0.017 [0.010] EEC/EU member -0.601 [0.383] Lagged DV 1.840*** [0.134] Lagged Level --.-Cut1 Cut2 Cut3 Cut4

4.040*** [0.971] 6.278*** [1.022] 9.221*** [1.123] --.--

2 De jure Ord. Probit 0.382** [0.185] -0.351 [0.320] -0.006 [0.028] -2.361*** [0.651] -0.007*** [0.002] -0.005 [0.005] 0.002 [0.002] 0.122*** [0.042] -0.050 [0.063] 0.058*** [0.056] 0.105*** [0.038] 0.474*** [0.124] 0.038*** [0.008] -0.306 [0.219] 1.630*** [0.089] --.-6.669*** [1.022] 7.369*** [1.046] 9.722*** [1.049] --.--

32

3 4 5 Δ De facto (RR) Δ De jure De facto (KS) Ord. Probit Ord. Probit Cox P. H. 0.660*** 0.308* 0.342** [0.202] [0.161] [0.166] -0.929** -0.159 -0.997*** [0.392] [0.318] [0.343] -0.006 -0.011 0.019 [0.044] [0.029] [0.025] -2.932** -2.550*** -2.562** [1.428] [0.748] [1.292] -0.004* -0.006*** -0.002 [0.002] [0.002] [0.002] -0.005 -0.007** -0.018** [0.006] [0.003] [0.008] -0.001 0.002 0.001 [0.003] [0.002] [0.003] 0.122** 0.129*** 0.083 [0.054] [0.041] [0.051] 0.039 0.025 0.122 [0.081] [0.058] [0.077] -0.165*** 0.130** 0.274*** [0.053] [0.052] [0.045] 0.011 0.044 0.037 [0.049] [0.040] [0.047] 0.132 0.365*** -0.072 [0.125] [0.113] [0.129] 0.018 0.028*** 0.048*** [0.011] [0.008] [0.011] -0.498 -0.089 -0.195 [0.674] [0.282] [0.465] -0.159*** -0.207*** --.-[0.053] [0.076] -0.987*** -0.531*** --.-[0.078] [0.045] -4.935* -0.899 --.-[1.185] [0.918] -3.854*** -0.223 --.-[1.181] [0.891] -2.738** 0.255 --.-[1.166] [0.885] -2.179** 4.327*** --.-[1.170] [0.917]

Model Variable

1 De facto (RR) Ord. Probit

2 De jure Ord. Probit

Cut5

--.--

--.--

Cut6

--.--

--.--

1593 101 -910.609

1523 98 -767.147

Observations Number of countries Log- likelihood

3 4 Δ De facto (RR) Δ De jure Ord. Probit Ord. Probit 2.604*** [1.170] 3.308*** [1.155] 1434 96 -429.227

[clustered standard errors in brackets] * significant at 10%; ** significant at 5%; *** significant at 1%

33

4.673*** [0.917] 5.418*** [0.915] 1516 97 -558.761

5 De facto (KS) Cox P. H. --.---.-1528 98 -3170.324

Figure 1.

34

TABLE 2. ESTIMATES OF THE DETERMINANTS OF REAL EXCHANGE RATE LEVELS, 1975-2004 Model PTA Base Base Trade # PTA PTA Coverage (Non-base) Trade/GDP (log %) Agricultural/material exp Manufactured exports GDP (log) GDP per capita (log) Inflation (%) Capital Open POLITY score IFI/GDP (log %) EEC/EU member Lag DV Constant Observations Number of countries F

6 REER (log) -0.025* [0.014] 0.065 [0.108] 0.002 [0.003] -0.015 [0.171] 0.000 [0.000] 0.002** [0.001] 0.000 [0.000] -0.156* [0.093] 0.215** [0.085] 0.012*** [0.004] 0.005 [0.005] 0.000 [0.001] 0.003 [0.024] 0.029 [0.022] 0.822*** [0.055] 1.636 [1.277] 869 63 404.61

7 REER (3 yr. MA log) -0.035** [0.016] -0.017 [0.087] 0.001 [0.002] 0.050 [0.052] -0.001 [0.000] -0.002** [0.001] 0.000 [0.000] -0.299*** [0.098] 0.307*** [0.085] -0.007* [0.004] -0.000 [0.005] -0.001 [0.001] -0.078*** [0.020] -0.003 [0.020] 0.863*** [0.031] 3.822*** [1.227] 846 63 813.43

OLS with unit and year fixed effects (with clustered standard errors in brackets) * significant at 10%; ** significant at 5%; *** significant at 1%

35

References Bahmani-Oskooee, Mohsen and Ilir Miteza. 2002. “Do Nominal Devaluations Lead to Inflation Real Devaluations in LDCs?” Economics Letters 74 (3): 385-91. Bank for International Settlements. 2006. “The New BIS Effective Exchange Rate Indices.” BIS Quarterly Review (March) (http://www.bis.org/statistics/eer/index.htm). Bautista, R. 1981. “Exchange Rate Changes and LDC Export Performance Under Generalized Currency Floating.” Weltwirtschaftliches Archives 117, 443-68. Bearce, David and Mark Hallerberg. 2006. “Democracy and De Facto Exchange Rate Regimes.” Paper presented at the 2006 meeting of the IPES, Princeton. Beck, Nathaniel, Jonathan Katz, and Richard Tucker. 1998. “Taking Time Seriously: Time-Series CrossSectional Analysis with a Binary Dependent Variable.” American Journal of Political Science 42(4): 1260-1288. Beck, Thorsten, George Clarke, Alberto Groff, Philip Keefer, and Patrick Walsh. 2001. “New Tools in Comparative Political Economy: The Database of Political Institutions.” World Bank Economic Review 15: 165-76. Bergsten, C. Fred. 2006. “The US Trade Deficit and China.” Testimony Before the Hearing on USChina Economic Relations Revisited, Committee on Finance, United States Senate, March 29 (http://www.iie.com/publications/papers/paper.cfm?ResearchID=611). Bernhard, William, and David Leblang. 1999. “Democratic Institutions and Exchange-Rate Commitments.” International Organization 53(1): 71-97. Campa, Jose Manuel, and Linda Goldberg. 2002. “Exchange Rate Pass-Through Into Import Prices: A Macro or Micro Phenomenon?” NBER Working Paper 8934. Cambridge: NBER. Caprio, Gerard, and Daniela Klingebiel. 2003. “Episodes of Systemic and Borderline Financial Crises.” World Bank Research dataset (http://www1.worldbank.org/finance/html/database_sfd.html). Carranza, Mario. 2003. “Can Mercosur Survive? Domestic and International Constraints on Mercosur.” Latin American Politics and Society 45(2): 67-104. Chinn, Menzie. 2005. "Getting Serious about the Twin Deficits," Special Council Report No. 10 (Council on Foreign Relations). http://www.cfr.org/content/publications/attachments/Twin_DeficitsTF.pdf Chinn, Menzie, and Hiro Ito. 2006. “What Matters for Financial Development? Capital Controls, Institutions, and Interactions,” Journal of Development Economics, 81(1): 163-192. Corden, W.M. 1982. “Exchange Rate Protection," in The International Monetary System Under Flexible Exchange Rates -- Global, Regional, and National: Essays in Honor of Robert Triffin, ed. Richard Cooper, Peter Kenen, Jorge Braga de Macedo, and Jacques Van Ypersele. Cambridge: Ballinger, 17-34.

36

Destler, I.M. and C. Randall Henning. 1989. Dollar Politics: Exchange Rate Policymaking in the United States. Washington, DC: Institute for International Economics. Donovan, D. 1981. “Real Responses Associate With Exchange Rate Action in Selected Upper Credit Tranche Stabilization Programs.” IMF Staff Papers 28: 698-727. Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great Depression, 1919-1939. New York: Oxford University Press. Eichengreen, Barry. 2006. “Global Imbalances: The New Economy, the Dark Matter, the Savvy Investor, and the Standard Analysis.” Available at http://www.econ.berkeley.edu/%7Eeichengr/matter.pdf. Eichengreen, Barry, and Ricardo Hausmann. 1999. “Exchange Rates and Financial Fragility.” NBER Working Paper 7418. Cambridge: NBER. Edwards, Sebastian. 1988. Exchange Rate Misalignment in Developing Countries. Baltimore: Johns Hopkins University Press. _______________. 1994. “Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries,” in Estimating Equilibrium Exchange Rates, ed. J. Williamson. Washington DC: Peterson Institute. Frankel, Jeffrey. 1994. “The Making of Exchange Rate Policy in the 1980s, in Martin Feldstein, ed., American Economic Policy in the 1980s. Chicago: University of Chicago Press, 293-341. Frieden, Jeffry. Forthcoming. “Globalization and Exchange Rate Policy.” In The Future of Globalization, ed. Ernesto Zedillo. New York: Routledge, 344-357. ____________. 1991. “Invested Interests: The Politics of National Economic Policies in a World of Global Finance.” International Organization 45(4): 425-451. ____________. 2002. “Real Sources of European Currency Policy: Sectoral Interests and European Monetary Integration.” International Organization 56(4): 831-860. Frieden, Jeffry A., and J. Lawrence Broz. 2006. “The Political Economy of Exchange Rates.” Oxford Handbook of Political Economy, ed. Barry Weingast and Donald Wittman. New York: Oxford University Press. ________________________________. 2001. “The Political Economy of International Monetary Relations.” Annual Review of Political Science 4: 317-343. Frieden, Jeffry A., Piero Ghezzi, and Ernesto Stein. 2001. “Politics and Exchange Rates: A CrossCountry Approach to Latin America,” in The Currency Game: Exchange Rate Politics in Latin America, edited by Jeffry Frieden and Ernesto Stein. Baltimore: Johns Hopkins University Press. Frieden, Jeffry A. and Lisa Martin, 2002. “International Political Economy: The State of the SubDiscipline,” in Ira Katznelson and Helen Milner, Political Science: The State of the Discipline. New York: Norton. Gleditsch, Kristian Skrede. 2008. Modified Polity P4 and P4D Data, Version 2.0.

37

(http://privatewww.essex.ac.uk/~ksg/Polity.html). Goldberg, Pinelopi, and Michael Knetter. 1997. “Goods Prices and Exchange Rates: What Have We Learned?” Journal of Economic Literature 35: 1243–1292. Gowa, Joanne. 1983. Closing the Gold Window: Domestic Politics and the End of Bretton Woods. Cornell Studies in Political Economy. Ithaca: Cornell University Press. Hallerberg, Mark. 2002. “Veto Players and Monetary Commitment Technologies.” International Organization 56(4): 775-802. Hefeker, Carsten. 1997. Interest Groups and Monetary Integration. Boulder, CO: Westview Press. Kenen, Peter. 1969. “The Theory of Optimum Currency Areas, in Monetary Problems in the International Economy, ed. Robert Mundell and Alexander Swoboda. Chicago: University of Chicago Press. Krueger, Anne. 1999. “Are Preferential Trade Arrangements Trade-Liberalizing or Protectionist?” Journal of Economic Perspectives 13(4): 105-124. Levy-Yeyati, Eduardo. and Federico Sturzenegger. 2004. “Classifying Exchange Rate Regimes: Deeds vs. Words.” European Economic Review. Lipson, Charles. 2003. Reliable Partners: How Democracies Have Made a Separate Peace. Princeton Press. Mansfield, Edward, and Helen V. Milner. 1999. “The New Regionalism.” International Organization 53(3): 589-627. Mansfield, Edward D., Helen V. Milner, and B. Peter Rosendorff. 2002. Why Democracies Cooperate More: Electoral Control and International Trade Agreements. International Organization 56 (3): 477-514. Mansfield, Edward, Helen V. Milner, and Jon C. Pevehouse. 2007. “Vetoing Co-operation: The Impact of Veto Players on Preferential Trade Agreements.” British Journal of Political Science 37(3): 403-432. McKinnon, Ronald I. 1962. “Optimum Currency Areas.” American Economic Review 53: 717-725. McKinnon, Ronald I., and K.C. Fung. 1993. “Floating Exchange Rates and the New Interbloc Protectionism,” in Protectionism and World Welfare, ed. Dominick Salvatore. Cambridge: Cambridge University Press, 221-244. Milner, Helen V. 1999. “The Political Economy of International Trade.” Annual Review of Political Science 2: 91-114. Morgan, T. and A. Davis. 1982. “The Concomitants of Exchange Rate Depreciation: Less Developed Countries, 1971-1973.” Economic Development and Cultural Change 31: 101-30. Mundell, Robert. 1961. “A Theory of Optimum Currency Areas.” American Economic Review. 51: 657664.

38

Mussa, Michael. 2005. “Sustaining Global Growth While Reducing External Imbalances,” Chapter 6 in C. Fred Bergsten, ed., The United States and the World Economy: Foreign Economic Policy for the Next Decade. Washington, DC: Peterson Institute for International Economics. Odell, John. 1982. US International Monetary Power: Markets, Power, and Ideas as Sources of Change. Princeton: Princeton University Press. Olivei, Giovanni, P.. 2002. “Exchange Rates and the Prices of Manufacturing Products Imported Into the United States.” New England Economic Review (First Quarter), 3-18 (http://www.bos.frb.org/economic/neer/neer2002/neer102a.pdf). Reinhart, Carmen, and Kenneth Rogoff. 2004. “The Modern History of Exchange Rate Arrangements: A Reinterpretation.” Quarterly Journal of Economics 119 (February). Shambaugh, Jay C. 2004. The Effect of Fixed Exchange Rates on Monetary Policy. Quarterly Journal of Economics 119 (February): 301-52. Simmons, Beth. 1994. Who Adjusts? Domestic Sources of Foreign Economic Policy During the interwar Years. Princeton: Princeton University Press. Smith, James McCall. 2000. “The Politics of Dispute Settlement Design: Explaining Legalism in Regional Trade Pacts.” International Organization 54 (1): 137-180. Staiger, Robert W., and Alan O. Sykes. 2008. “‘Currency Manipulation’ and World Trade.” Unpublished manuscript. Stanford University. Valderrama, Diego. 2004. “Does a Fall in the Dollar Mean Higher U.S. Consumer Prices?” Federal Reserve Bank of San Francisco Economic Letter, Number 2004-21 (August 13). Vayrynen, Raimo. 2003. “Regionalism: Old and New.” International Studies Review 5 (1): 25-51.

39