Taming Financiers: the Political Economy of Exchange Rate Regime Determination in Transition Economies

Abstract: In this paper I develop a finance-based political economy model in which the interests and behavior of different types of banks—state-owned, private domestic, and foreign—are mediated by the ownership and institutional structures of the domestic financial system and affect the choice and sustainability of exchange rate regimes. This paper also presents an empirical investigation of the exchange rate regime choices of the twenty-five transition economies in Eastern Europe during the period 1990–2004. The primary analysis uses binary and multinomial logistic models on panel data. Also addressed in the analysis is the question of endogeneity and causality that arise in this context by using an instrumental variables approach via the generalized method of moments estimations. The analysis proposes the method of banking and industrial privatization as a new instrument for financial development. Empirical results support the premise that countries with financial systems characterized by a greater participation by foreign banks in financial intermediation, accompanied by strong monetary and regulatory institutions, are more willing and able to commit to and sustain fixed exchange rate arrangements than countries with financial systems dominated by incumbent state-owned banks. The paper also shows that the de facto exchange rate regimes in EE diverge considerably from what is announced.