Financial Liberalization and the Stability of Currency Pegs

Abstract:     
This paper analyzes how the strategies of domestic firms borrowing abroad complicate the interaction between central banks and foreign exchange speculators. If we define financial liberalization as the degree of freedom given to domestic firms to borrow abroad, we find that in the early stages of financial liberalization, foreign borrowing does not affect the stability of the currency peg, but in the advanced stages of financial liberalization, foreign borrowing destabilizes currency pegs. When this happens, we show that policies to curb currency speculators have no effect. The paper thus formalizes the critical juncture where financial liberalization and currency pegs become incompatible policy goals.

Number of Pages in PDF File: 38

Keywords: Corporate borrowing, currency speculators, central bank intervention, exchange rate pegs

JEL Classification: G15, F31, F34, D84

working papers series