fiscal policy cycles and the exchange rate regime in developing countries

European Journal of Political EconomyŽ .Vol. 15 1999 569–580

Fiscal policy cycles and the exchange rateregime in developing countries

Ludger Schuknecht )

World Trade Organization, Rue de Lausanne 154, 1206 GeneÕa 21, Switzerland

Received 1 May 1997; received in revised form 1 August 1998; accepted 1 November 1998

Abstract

The paper studies empirically fiscal policies around elections in 25 developing countriesas affected by the exchange rate regime. The purpose is to consider whether countries withflexible exchange regimes are less likely to engage in expansionary fiscal policies beforeelections because such policies can result in devaluations and inflation which affectgovernment popularity adversely. The empirical results show that governments indeed try toimprove their re-election prospects by expansionary fiscal policies, but only in countrieswith fixed exchange rates and adequate reserve levels. For some countries, this raisesdoubts about the usefulness of fixed exchange rates for stabilizing the macro economy,unless reforms of the institutional framework reduce the scope for election-oriented fiscalexpansion. q 1999 Elsevier Science B.V. All rights reserved.

JEL classification: F41; E62; H62

Keywords: Elections; Political business cycles; Fiscal policies; Deficits; Developing countries

1. Introduction

Many studies have examined whether democratic governments in industrialcountries adjust macroeconomic policy-making around the election date to en-hance their re-election prospects, and thereby generate political business cycles

) E-mail: [email protected]

0176-2680r99r$ - see front matter q 1999 Elsevier Science B.V. All rights reserved.Ž .PII: S0176-2680 99 00025-7

( )L. SchuknechtrEuropean Journal of Political Economy 15 1999 569–580570

Žfor surveys, see Alesina, 1988; Nordhaus, 1989; Willett, 1989; Gartner, 1993,¨.1994 . Very few studies, however, have discussed the influence of exchange rate

Žregimes on political business cycles e.g., Willett and Mullen, 1982; or Assale and. 1Larrain, 1994 . Furthermore, empirical studies of political business cycles in

Ž .developing countries are still scarce. Bates 1988 discusses public investmentŽ .cycles in Zambia in the 1960s and Krueger and Turan 1993 consider such cyclesŽ .in Turkey between 1950 and 1980. In Schuknecht 1996 , I find fiscal policy

cycles of the ‘‘Nordhaus’’-type for a panel of 35 developing countries, wheregovernments pursue expansionary fiscal policies before elections and fiscal auster-ity afterwards. However, in that study I did not analyze the implications ofdifferent exchange regimes on fiscal cycles.

The purpose of this paper is to address this latter issue, i.e., to examine theimpact of the exchange rate regime on election-oriented fiscal policy making indeveloping countries. From a policy perspective, this issue appears quite impor-

Ž . Žtant. Calvo 1995 , for instance, argues that the Mexican crisis with a collapse of.the fixed parity of the peso to the U.S. dollar partly resulted from the significant

increase in the quasi-fiscal deficit associated with the extension of credit, e.g.,through development banks, before the elections in late 1994.

In this study, I look at 25 developing countries that held elections during the1978 to 1992 period to determine whether flexible exchange regimes reduce theincentive for election-oriented expansionary fiscal policies. The link is that suchpolicies can stimulate devaluations and inflation, which, in turn, adversely affectgovernment popularity. 2 In fixed exchange rate regimes, governments face less ofthis trade-off and, therefore, have a greater interest in ‘‘opportunistic’’ fiscalexpansion before elections. In other words, short-term policy incentives mayundermine the long-term disciplining effect of fixed exchange rates on macroeco-

1 There is a considerable body of literature discussing the impact of the exchange regime onŽ .macroeconomic policy making. Westbrook and Willet 1996 provide an overview of exchange rates as

Ž . Ž .a nominal anchor. Aghevli et al. 1991 and De Kock and Grilli 1993 discuss the implications ofŽ .different exchange regimes on fiscal policies. Baxter and Stockman 1989 find little systematic

difference in macroeconomic aggregates under different exchange regimes, although the standarddeviation in government consumption was found to fall during floating-rate periods in 15 of 22

Ž .countries. Bayoumi and Eichengreen 1994 compare output and price responses under fixed andflexible exchange regimes. Fiscal cycles as affected by the exchange regime in OECD countries are

Ž .analyzed by Clark and Hallerberg 1998 .2 The sample includes developing countries that held elections during the observation period, and for

which data for much of the observation period was available. Although most sample countries aredemocracies, some elections may not be considered democratic in a strict interpretation of the term.However, military or authoritarian regimes that face public discontent or strive for confirmation of their

Ž .position in elections also have reason to enhance support with populist policies Tullock, 1987 . Thehypothesis and results discussed in this paper, therefore, can apply independently of the politicalregime under which elections are held. See the table in Appendix A for a list of the sample countriesand their exchange regime between 1978 and 1992.

( )L. SchuknechtrEuropean Journal of Political Economy 15 1999 569–580 571

nomic policies via the balance of payments constraint. The latter effect is stressedŽ .in much of the previous literature see Aghevli et al., 1991 . The results support

these hypotheses and reveal significant empirical evidence for fiscal policy cyclesonly in countries with fixed exchange rates and sufficient reserves. These findingscan have important implications for the choice of exchange regime.

Section 2 discusses the main hypothesis of the paper. This hypothesis is testedempirically in Section 3, which is followed by a summary and policy implicationsin Section 4.

2. Fiscal policies and the exchange regime in developing countries

2.1. The underlying model and the literature

I shall apply the ‘‘Nordhaus-approach’’ to analyze fiscal policies aroundelections: that is, governments are proposed to stimulate their economies withexpansionary fiscal or monetary policies before elections to gain votes, and after

Žthe elections, reduce fiscal deficits or inflation with austerity measures Nordhaus,.1975 . The earlier literature assumed adaptive expectations. Persson and Tabellini

Ž . Ž .1990 and Rogoff 1990 have shown that Nordhaus-cycles can also emerge withrational expectations. The other main types of model — the ‘‘partisan-models’’— generate policy cycles as a result of ideological differences between political

Žparties with different preferences for inflation and unemployment see HibbsŽ . Ž . Ž .1977 or Alesina 1987 for rational partisan models and Kapopoulos 1995 for

.an extension to open economies .In many developing countries, the Nordhaus-approach seems more appropriate

because the distinctions between political parties frequently do not exhibit thetypical Western right–left pattern. The Nordhaus-approach is also supported bythe above-mentioned studies by Bates, Krueger and Turan, Calvo and Schuknecht.

2.2. Hypotheses on fiscal policies and the exchange regime

The question at issue is whether governments adjust fiscal policies aroundelections. 3 The exchange rate regime is also of crucial importance for theeffectiveness of election-oriented policy-making, and fixed exchange regimes are

3 Ideally, a more refined analysis taking into account pre-election popularity, the uncertainty aboutŽthe election outcome and the narrowness of election-results would be preferable Schneider and Frey,

.1988 , but lack of appropriate data for most developing countries constrains the study to this morecrude hypothesis.


much more conducive to expansionary policies before elections than flexible ones.Flexible exchange rates result in a steeper short-run Phillips curve becauseincreased import demand rapidly feeds into domestic inflation through devalua-

Ž .tions Willett and Mullen, 1982; Tornell and Velasco, 1995 . Rising import pricesare also unpopular with the country’s elite and urban voters, who often consumemany imported products, including food. These trade-offs reduce the incentive forpursuing expansionary policies under flexible exchange rates.

Implementing expansionary fiscal policies under a system of flexible exchangeŽ .rates will not stimulate inflation through depreciation if: i the deficit is not

Ž . Ž .monetized; ii capital mobility is sufficiently high; and iii rising interest rateslead to capital inflows which finance the expansion. Even if the first twoassumptions are met, in developing countries, it is unlikely that the governmentwill permit interest rates to rise enough during an election period to attractsufficient international capital. In fact, in many countries, interest rates are

Ž .controlled see, e.g., Killick, 1993; Krueger, 1993 , and, if inflation rises, realinterest rates decline, hence deterring rather than attracting foreign inflows. Inaddition, political uncertainty around elections can reduce the likelihood ofsignificant capital inflows in this period.

Fixed exchange rates allow an increase in current consumption through a highertrade deficit without additional inflation. The trade-off in terms of future consump-tion through depleted reserves or higher debt may not worry governments preoccu-pied with re-election. 4 Despite their interest in popularity-enhancing policies,however, governments will not want to encounter balance of payments problemsjust before an election. They will, therefore, be only likely to apply expansionaryfiscal policies under fixed exchange rates when reserves are sufficient to financethe pre-election surge in import demand.

An analysis of fiscal policy in developing countries also needs to take intoconsideration programs with international financial institutions such as the Interna-

Ž .tional Monetary Fund IMF . These programs usually provide access to moreinternational financing and contain conditionality that stresses economic stabiliza-tion, including fiscal consolidation. Programs supported by the IMF should,therefore, ‘‘harden’’ the government budget constraint and result in smaller fiscaldeficits. 5

4 Theoretically, a decline in international reserves could reduce the domestic money supply andcounteract fiscal expansion. However, governments are likely to offset such monetary contractionbefore elections.

5 It has been argued that programs with the international financial institutions relieve industrialcountry governments of the unpleasant task of imposing policy conditionality on developing countries

Ž .which might be unpopular with their domestic electorate Vaubel, 1986 . Developing country govern-ments, by the same token, can attribute the negative effect of austerity measures to the international

Ž .financial institutions and, thereby, protect their political support Frey and Eichenberger, 1994 .


3. The empirical study

3.1. Methodology

3.1.1. TechniqueRegressions with annual panel data for the period 1978–1992 were run on a

25-country sample with a fixed-effects model, which assumes that countries havecommon slopes but different intercepts. Unit root tests were conducted on allindependent variables and the occurrence of co-integration can be rejected at the95% level for almost all variables.

The following panel regression was tested:Def sa Const qb Elect qg Var q´i t i t i t ji t ji t i

where ‘‘Def ’’ stands for the fiscal deficit for country i in period t, ‘‘Elect’’i t

represents the variable capturing the influence of elections, and ‘‘Var ’’ stands forj

the impact of other factors, such as terms of trade changes, the trade-orientednessof a country, catastrophes and IMF-supported programs. The study thus follows

Ž .established techniques as applied, for example, by Hibbs 1987 , Alesina andŽ . Ž .Roubini 1992 , and Schuknecht 1996 .

3.1.2. Dependent ÕariableThe overall fiscal balance of central government, expressed as a share of GDP,

serves as the dependent variable for the analysis of fiscal policies around elections,as it reflects the combined effect of expenditure and revenue measures.

3.1.3. Election ÕariableMost importantly for the analysis, a dummy variable is introduced to reflect the

effect of elections. Only country-wide general, legislative, or presidential electionsare considered, depending on the political system of the sample countries. Theelection variable takes the value of one in the period when expansionary policiesare expected and minus one when a post-election contraction is anticipated. In allother periods, it is set as zero. However, in many countries the fiscal year and thecalendar year do not coincide. Therefore, the variable value is set relative to itsposition during the fiscal year, in order to be consistent with the other fiscal

Ž Ž . .variables it is hypothesized to influence see Schuknecht 1996 for more details .In a first estimation, the fiscal balance is estimated independently of the

Ž .exchange regime. This estimation replicates the findings of Schuknecht 1996 forthe somewhat smaller sample in this study. In a second step, two election variablesmeasure the impact of elections on countries with fixed and flexible exchangeregimes separately. 6 A significant coefficient is in particular expected for fixedexchange regime countries.

6 The exchange rate regime is derived from the IMF International Financial Statistics. The latterdistinguishes countries with more flexible arrangements, on the one hand, and those with no or verylimited flexibility, on the other hand.


In a third step, the impact of elections on fiscal policies in fixed exchangeregime countries is analyzed, as influenced by the level of reserves. The electionvariable for fixed exchange regime countries is split into three variables, distin-guishing countries with reserves of less than 2 months of imports, between 2 and 4months of imports, and more than 4 months of imports, respectively. The largestcoefficient and the highest probability of significance is expected for the variablereflecting reserves of more than 4 months of imports.

3.1.4. Other independent ÕariablesOther independent variables were chosen to reflect the domestic economic

situation of the countries and important external influences.Lagged dependent variable: all estimations include a lagged dependent variable

with an expected positive coefficient. Government administrations are constrainedby budgets and the current budget largely determines the next period’s appropria-

Ž .tions Niskanen, 1971 . This ‘‘inertia’’ provides stability and predetermines fiscaldeficit patterns.

Output growth: fiscal deficits are affected by real economic activity. On therevenue side, for example, company tax receipts depend to some extent on theposition on the business cycle. On the expenditure side, spending on the unem-ployed is also highly cyclical, although this is probably less relevant in developingcountries. Cyclical factors in the deficit are, thus, captured by a real economicgrowth variable. A negative sign for the coefficient is expected, as higher growthis likely to lead to lower deficits.

Terms of trade: effects of changes in the terms of trade are also examined. IfŽthe external shock is positive i.e., countries experience an improvement in their

.terms of trade , we expect output to increase. This should raise fiscal revenue andimprove the fiscal balance. Declines in the terms of trade, on the other hand,should lower revenue and deteriorate the fiscal balance. Furthermore, they requirehigh government expenditure if, for example, public enterprises are not allowed toadjust their pricing policies to changes in export and import prices and requiremore support. This implies an expected positive sign of the coefficient for thefiscal balance.

Trade-orientation: a variable that reflects a country’s trade-orientation is de-fined as the ratio of the sum of imports and exports over GDP. It is expected to becorrelated with an improved fiscal balance, as the leakage of demand abroad andresulting costs from external payment difficulties make high fiscal deficits less

Ž .attractive than in less-trade oriented countries Lindbeck, 1976 .Catastrophes: shocks are incorporated as dummy variables taking the value of

one during periods of catastrophes, such as floods, earthquakes, or the eruption ofvolcanos. It is anticipated that the government’s fiscal position is weakenedthrough budget-financed relief measures and revenue loss after such catastrophes.The variable is, therefore, expected to have a negative coefficient in estimations ofthe fiscal balance.


IMF-supported programs: the estimations include three types of programssupported by the IMF. Dummy variables stand for structural adjustment facilityŽ . Ž .SAF and enhanced structural adjustment facility ESAF arrangements, stand-byarrangements, and extended fund facility arrangements. The variables take thevalue of one when the respective program has been in force for at least 6 monthsof the respective fiscal year and are set at one-half when the particular programcovers at least a full quarter of the fiscal year. 7 All IMF-supported programs arehypothesized to have a positive effect on fiscal balances.

3.2. Results

The results confirm the hypothesis that fiscal policy cycles are less prevalentunder flexible exchange regimes. The first estimation shows the effect of electionson the overall fiscal balance for the total sample, irrespective of the exchange

Ž .regime Table 1, column 1 . The estimation indicates an election-related expansionin the fiscal deficit by three quarters of a percent of GDP, or nearly 20% of themean deficit of the sample. Budgetary inertia, as represented by the laggeddependent variable and natural catastrophes, also have a strong significant effecton fiscal deficits. The coefficients of the variables reflecting the ‘‘openness’’ of aneconomy, SAFrESAF arrangements and EFF arrangements come close to the95% level of significance; output growth and terms of trade do not exhibit asignificant effect on fiscal deficits.

The next estimation shows that only countries with fixed exchange regimesŽ .exhibit fiscal cycles column 2 . In countries with fixed arrangements, the fiscal

deficit worsens by almost 1% of GDP around elections, which corresponds toabout 25% of the mean fiscal deficit. The coefficient for the election variable isnot significant for countries with flexible exchange regimes. Moreover, the resultsdo not change when an exchange regime variable is introduced in this estimationto test whether there is a systematic rather than only an election-induced differencein the fiscal position between countries with fixed and flexible exchange regimes. 8

There is also a support for the claim that countries pursue election-orientedŽ .policies under fixed exchange rates only with ‘‘adequate’’ reserves column 3 .

ŽCountries with reserves of more than 4 months of imports about 40% of all.observations for fixed exchange regime countries show a significant increase in

the election-related deficit by one and one quarter percent of GDP. The coeffi-

7 Programs under the SAF and ESAF are assumed to have a lagged effect on the fiscal balance, asstructural policy reforms — a key component of such programs — initially often lead to higher fiscaldeficits.

8 If an exchange regime variable exhibited significantly higher deficits for fixed exchange regimecountries than for those with flexible ones, and if this variable reduced or eliminated the significance ofthe election variable, this would speak against the business cycle hypothesis. This is not the case, whichshows the robustness of the estimations towards other specifications.


Table 1Summary of estimation results, 1978–1992 period

Dependent variable Overall fiscal balance

Ž .Elections: Coefficients T-statisticsUUŽ .Elections — independent of y0.74 y2.98

exchange regimeŽ . Ž .Elections — flexible y0.43 y1.08 y0.43 y1.07

exchange regimeUUŽ .Elections — fixed y0.93 y2.67

exchange regimeElections — fixedexchange regimeand reserves of:

Ž .less than 2 months of imports y0.38 y0.48Ž .between 2 and 4 months y0.79 y1.23

of importsUŽ .more than 4 months y1.24 y2.50

of imports

aOther independent variables:UU UU UUŽ . Ž . Ž .Lagged dependent variable 0.64 14.6 0.64 14.3 0.64 14.2

Ž . Ž . Ž .Output growth 0.03 0.64 0.03 0.70 0.03 0.65Ž . Ž . Ž .Terms of trade 0.02 0.24 0.01 0.11 0.01 0.07

b Ž . Ž . Ž .Trade orientedness 2.96 1.57 3.02 1.53 3.00 1.51UU UU UUŽ . Ž . Ž .Natural catastrophes y6.68 y4.14 y6.70 y4.10 y6.89 y4.16

IMF-supported programs:b Ž . Ž . Ž .SAFrESAF arrangement 4.57 1.75 4.82 1.82 4.93 1.85

Ž .one period lagŽ . Ž . Ž .EFF arrangement 1.19 1.89 1.24 1.89 1.25 1.91Ž . Ž . Ž .Stand-by arrangement 0.18 0.38 0.15 0.30 0.16 0.32

Number of observations 301 291 2912R adjusted 0.65 0.64 0.64

Sources: International Monetary Fund, 1970–1995a,b; International Monetary Fund, 1995a,b; WorldBank, 1970; Europa World Year Book, 1995.U

Significant at 5% level;UU

significant at 1% level.a Individual country intercepts not presented.b Dickey–Fuller-test statistics just below critical value of 95% significance.

cients for the two election variables for countries with reserves of less than 4months of imports, on the other hand, are not significant. If these latter twovariables are dropped, the significance of the other variables is slightly moreaccentuated.

These findings can be usefully linked with the recent new institutional eco-Žnomics literature dealing with budgetary institutions Von Hagen and Harden,.1994; Alesina et al., 1995; Campos and Pradhan, 1996 and the political economy

Ž . Žliterature which advocates constitutional rules for a survey, see Mueller, 1989;.Tanzi and Schuknecht, 1999 . These authors argue that the institutions of a


country are the key to maintaining fiscal discipline, which, in turn, has proven tobe an important element of the countries’ growth performance. 9 Fixed exchangeregimes are, thus, more likely to work when strong fiscal rules, budgetaryinstitutions and checks and balances in the political process reduce the govern-ment’s scope for short-term fiscal expansion, thereby increasing the credibility ofthe exchange regime. The above-mentioned studies find that most developing andsome industrialized countries have relatively weak budgetary institutions, as domany of the countries in the sample used by this study.

4. Conclusion

The results reported in this paper support the proposition that governments indeveloping countries frequently engage in election-oriented expansionary fiscalpolicies. This is particularly the case when fixed exchange rates reduce thelikelihood of higher inflation and higher import prices through expansion-induceddevaluation, and when adequate reserve levels soften the short-term balance-of-payments constraint. In fact, the results are not inconsistent with governmentsstrategically accumulating reserves between elections and drawing them down aselections approach. 10

Acknowledgements

Comments from Ke-young Chu, Sanjeev Gupta, Louis Levy-Garboua, Jacob deHaan, Mukela Luanga, Peter Moser, Marcelo Olarreaga and Tom Willett, and twoanonymous referees are highly appreciated. The views expressed here are theauthor’s own and should not be construed as representing the WTO.

( )Appendix A. Sample countries and their exchange regime 1978–1992

Countries with flexible Countries with fixedexchange regimes exchange regimes

Ž . Ž .Argentina 1978–1990 Argentina 1991–92Brazil Bangladesh

9 Ž .For a survey of cross-country growth analyses, see Brunetti 1997 . Brunetti finds that policyvolatility, mainly defined as monetary and fiscal stability, is one of the most successful explanatoryvariables for differing growth performance across countries.

10 ŽThe possible endogeneity of reserves and the option to use foreign exchange rationing which has.featured prominently in many developing countries with fixed exchange rates in the past to increase

support at the polls were pointed out by an anonymous referee.


Ž .Costa Rica 1980–1992 BarbadosŽ .Ecuador 1983–87, 1989–92 BotswanaŽ . Ž .Gambia 1986–1992 Costa Rica 1978–79

Ž . Ž .Guatemala 1989–1992 Ecuador 1978–82, 1988Ž .India 1979–1992 FijiŽ . Ž .Korea 1980–1992 Gambia 1978–85

Ž .Mexico Guatemala 1978–88Ž . Ž .Pakistan 1982–92 India 1978

Ž . Ž .Peru 1978–83, 1990–92 Korea 1978–79Philippines Malaysia

Ž .Thailand 1981 MaltaTurkey Mauritius

Ž .Uruguay Pakistan 1978–81Ž . Ž .Venezuela 1989–92 Peru 1984–89

St. VincentŽ .Thailand 1978–80, 1982–92

Trinidad and TobagoŽ .Venezuela 1978–88

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fiscal policy cycles and the exchange rate regime in developing countries

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