exchange rate systems and investor preferences

Exchange rate systems and investor preferences


This paper investigates whether or not floating exchange rates add an undesirable level of risk to international investment positions. For investors holding currencies, we find that fixed exchange rates are preferred to floating exchange rates, which supports the often-argued case that floating exchange rates do excessively increase the riskiness of investment. I argue that reliance on different types of foreign capital generates distinct capital-specific policy preferences. Furthermore, rather than simply mimicking the preferences of foreign investors, domestic groups are likely to promote policies that reduce their capital-specific risks and vulnerabilities. Panel logit models of exchange-rate regimes in emerging market countries from 1973 through 2000 demonstrate that higher levels of democracy bolster these effects. But as the currency market turmoil in Southeast Asia has dramatically demonstrated, globalization can amplify the costs of inappropriate policies. It looks at why so many countries have made a transition from fixed or "pegged" exchange rates to "managed floating" or "independently floating" currencies. It discusses how economies perform under different exchange rate arrangements, issues in the choice of regime, and the challenges posed by a world of increasing capital mobility, especially when banking sectors are inadequately regulated or supervised. The analysis suggests that exchange rate regimes cannot be unambiguously rated in terms of economic performance. Bretton Woods system of fixed exchange rates in the early 1970s, when the world’s major currencies began to float. At first, most developing countries continued to peg their exchange rates–either to a single key currency, usually the U.S. dollar or French franc, or to a basket of currencies. IMF’s special drawing right (SDR). Since the early 1980s, however, developing countries have shifted away from currency pegs–toward explicitly more flexible exchange rate arrangements.