The Link between the Exchange Rate Regime and Banking, Currency & Debt Crises Occurrences

The choice of the exchange rate regime is one of the most critical questions facing economies, as it has a great impact on their development, financial stability, effectiveness of monetary and fiscal policies and interdependence with the global financial system. While an ultimate decision depends on a number of economic and political factors, it is also of a great importance to take into account its crisis susceptibility, especially in the highly integrated global economy with increasingly volatile capital flows. This paper empirically investigates existence and a magnitude of an impact of the alternative exchange rate regimes on the likelihood that the banking, currency or debt crisis will occur in the economy.  The author tests two hypotheses: (1) a choice of a flexible exchange rate regime rather than fixed or intermediate regimes diminishes the likelihood that the three types of financial crisis (currency, debt and banking crises) occur in the country; and (2) intermediate regimes are more prone to financial crisis occurrence as compared to the corner options. By using a comprehensive data set including 51developed and developing countries over 2000-2012, the author conducts a logistic distribution to estimate the magnitude of the influence of the exchange rate regime and other appropriate control variables (macro fundamentals) on the likelihood of banking, debt and currency crises occurrence. The main empirical findings indicate that adopting a fixed exchange rate diminishes the likelihood of occurrence of the three types of crisis, thus strongly rejecting the first hypothesis. The second main result is that intermediate regimes are not more prone to financial crisis; rather, they turned out to be more immune than corner regimes to currency and banking crises. Thus, the author rejects the claim that intermediate regimes are more vulnerable to banking and currency crises; however, the author supports the hypothesis that intermediate regimes are more prone to debt crisis. 

Keywords: Financial crisis, Exchange rate regimes, Bipolar hypothesis