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Exchange rate unification under non-credibility: the Haitian economy.

Article Excerpt
Abstract

This paper builds on three strands of literature--Early Warning Systems (EWS), parallel exchange rates, and collapsing exchange rate regimes--by addressing the issue of credibility in the context of unification of the exchange rate in the Haitian economy. It takes the view that when policymakers are perceived as non-credible, economic agents resort to observation of the economy's performance to assess the imminence of reforms. They then readjust their own behavior, particularly in the area of asset holdings. This paper models the adjustment process using the EWS ratios. Data supports the idea that credibility of the reform mounts over time reaching 85 percent on the eve of the reform. (JEL E58, F31, 054)

Introduction

Motivated by the desire to predict financial crises, such as the one which occurred in East Asia in 1997, Early Warning System (EWS) literature has emerged to study the behavior of a variety of economic indicators. The objective of this literature is to find among these indicators the best proxies of economic performance. The optimal goal of this literature is to identify those indicators that policymakers can use as signaling devices of a potential crisis in their economy, allowing them to take preemptive measures.

This paper is an attempt to show that the EWS approach is relevant to the behavior of economic agents, allowing them to assess the credibility of current policies, to sense the imminence of policy changes, and to act accordingly.

More specifically this paper examines the case of the Haitian economy, a small open developing economy from 1985 to 1991. At that time, it was contemplating the unification of its official and parallel market exchange rates. As they sensed that the measure may not be popular, policymakers decided to announce the reform in advance, without any commitment to a date. At this point, economic agents tried to ascertain the credibility of the announcement by tracking of the performance of some EWS indicators. Based on these indicators, economic agents readjusted their own behavior, asset holdings, and spending patterns.

This paper's main contribution is to build a model which reproduces and tests the adjustment process taken by economic agents after the announcement. Such an adjustment process is made necessary due to the steady need for information about the true intentions of policymakers' regarding the economy.

Such a need is common in the literature on policy credibility, appearing, for instance, in Barro [1986, pp. 3-20], Cukierman and Liviatan [1991, pp. 99-127], and Drazen and Masson [1994, pp. 735-754]. In the first two papers, the need for information is necessary because of policymakers' incentive to masquerade their true objective for the economy. In the third paper, economic agents infer the intent of policymakers from their observation of the effects of these policies on the economy.

In the current paper, economic agents monitor the ratio of M2 to international reserves and the ratio of international reserves to imports in order to assess current economic conditions and the sustainability of the existing regime. That is, at each point in time, they build a subjective probability of policy changes (unification) occurring in the next period. This subjective probability summarizes their belief at that time about the sustainability of the current system. With such a probability in mind, they then readjust their asset holdings accordingly.

The results show that the EWS ratios provide good signaling devices to economic agents, allowing them to assess a policymaker's true intent for the economy. Their belief about the imminence of the reform reached 85 percent in August 1991, on the eve of reform.

The remainder of this paper is organized as follows: The next section describes the model used; the empirical methodology and the estimation results are discussed in the following section; and concluding remarks are contained in the final section.

Model

The economy considered is a small, open economy with an official fixed exchange rate (denoted 'e' and defined in units of domestic currency (gde) per unit of foreign currency ($US) which coexist with...

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