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Pegxit pressure

Fixed exchange-rate regimes reduce uncertainty, which may increase trade and encourage investment and capital flows. This column identifies and tests one reason why markets expect countries to abandon pegs and devalue their currencies – shocks to the value of their output. During the classical gold standard era, commodity price fluctuations determined expected devaluation by investors, as measured by currency risk. These results highlight how trade shocks in an integrated world may undermine fixed exchange rate regimes under limited fiscal adjustments.

Fixed exchange rate regimes are notoriously fragile (Obstfeld and Rogoff 1995). Although currency pegs allow countries to commit to disciplined monetary policy (Bordo and Kydland 1995) and to facilitate economic integration, they often sow the seeds of their own demise as they expose countries to a range of shocks. For example, small countries with fixed exchange rates are ‘interest rate takers’, as monetary policy is determined outside their domain; specialisation following trade integration may turn sour due to negative shocks to the terms of trade; capital inflows can reverse; and speculative attacks may precipitate the end of pegs. Given their fragility, investors often charge a premium (‘currency risk’) in expectation of ‘pegxit’ (i.e. leaving a fixed-exchange rate) followed by devaluation, especially in emerging market countries (Mitchener and Weidenmier 2015).

Since massive amounts of currency are traded daily, practitioners and researchers have developed an extensive range of models that attempt to explain currency risk premia in terms of fiscal and monetary factors. Perhaps surprisingly, relatively little of the academic research has focused on the real determinants of currency risk. Even less work has attempted to investigate causal determinants behind currency risk, since cause and effect are often difficult to disentangle. In ongoing research, we identify and test one reason why markets expect countries to abandon pegs and devalue their currencies, namely, shocks to the value of their output (Mitchener and Pina 2016).

Our research takes the perspective that countries often adopt fixed exchange rates to facilitate external trade, and explore how exogenous fluctuations in export prices, determined in world markets, affect the probability of expected currency devaluation. Using a theoretical model, we show that conflicting objectives from the government, together with nominal debt, may lead to a devaluation following a decrease in export-price shocks that reduces income and tax revenues. The main trade-off captured by the model is that the government chooses between larger income under a peg, where income fluctuates with export prices, and monetary independence outside of a peg that allows for the devaluation of nominal debt, where the value of independence does not fluctuate with export prices.

We then take the model to the data and show that commodity price fluctuations determine expected devaluation by investors, as measured by currency risk. The ideal experiment would feature random assignment of income shocks and many pegxits. In our empirical strategy, we get as close as possible to the ideal experiment by focusing on the classical gold standard era (1870-1913). We hand-collect novel high-frequency data that includes monthly measures of commodity and manufactured goods world prices, countries' principal exports, and currency risk measured from market expectations, for more than 40 years and 21 countries to test whether export-price shocks influence currency risk.

Our sample period, 1870-1913, is a particularly well-suited laboratory for understanding why countries abandon hard pegs since countries pegged to gold to facilitate trade, capital, and goods markets were unfettered, and many countries had relatively unspecialised production structures, exposing them to external trade shocks. Since many countries specialised in exports of raw materials and minerals, we exploit the ‘commodity lottery’ in our identification strategy. That is, commodity prices determined in world markets provide a plausibly exogenous source of variation for measuring the benefits of fixed exchange rates, since countries specialised in exporting products based on their pre-determined factor endowments. We focus on the prices of the principal export, instead of export prices or terms-of-trade, to isolate exogenous monthly variation and identify the causal impact of the principal-export price on currency risk under fixed exchange rates.

An illustration: Chile’s 19th century pegxit

Chile's experience in the late 1890s illustrates how negative export-price shocks can contribute to the breaking of a peg and how this effect is captured by currency risk. Chile had rejoined the gold standard on 1 June 1895, only to abandon it three years later in July 1898. During this period, Chile suffered several negative shocks, including a border dispute with Argentina that resulted in an arms race and an increased defence budget, as well as declining prices of its major exports. Figure 1 plots currency risk (the solid line, plotted on the right axis) together with the price index for nitrate (the dashed line, plotted on the left axis), Chile's most important export by value. Chile's adherence to the gold standard is represented by the shaded area. Between June 1895 and July 1898, we can see that the price of nitrate fell by 11.5%. The price of copper, Chile's second most important export, also decreased 3% between May 1898 and July 1898. Unsurprisingly, currency risk peaked just as Chile abandoned gold, while its exchange rate devalued shortly afterwards.

Figure 1 Currency risk and commodity prices: Chile, 1895-1898

Natural experiment results

Our empirical analysis examines the relationship between exogenous world export prices and currency risk using structural and reduced form models, which include a number of country-specific controls as well as time fixed-effects. The results show that export-price growth rates have a negative causal impact on currency risk. This finding is even stronger when emerging economies adhered to the gold standard, and in cases where the principal export accounts for a larger share of total exports.

Peggers into ‘beggars’

To shed some additional light on the model's underlying mechanism, we also investigate how export-price shocks affect currency risk through GDP. In the model, tax revenues are determined by income, which, in the presence of nominal debt, leads to changes in expected policy that translate into currency risk. Our empirical results show that export prices account for the variation in real GDP growth rates and that higher export-prices increase real GDP growth rates. These findings are consistent with our formulation of export-price fluctuations as shocks to the value of output. We explore this channel further and instrument GDP growth rates with export-price growth rates times the export-share of the principal export. The estimated 2SLS coefficients are negative and indicate that exogenous increases in GDP growth rates reduce currency risk, a result that is again consistent with the mechanism through which exogenous output shocks affect currency risk.

Lessons for the Eurozone

Our results demonstrate how real shocks put a strain on existing institutions through debt and fiscal pressures, even for hard pegs like the classical gold standard. They also highlight the importance of fiscal adjustments for the stability of hard pegs, and are relevant for the Eurozone. Although reforms that cap the use of debt may limit the temptation to leave pegs, the failure of the Stability and Growth Pact demonstrates the importance of developing alternative mechanisms that respond to real shocks and restore debt sustainability when exchange rates are fixed. One potential avenue would be to use the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) to provide fiscal adjustments following real shocks. Indexing debt payments to real shocks, for example, as measured by real GDP, is particularly promising as these shocks may be less prone to moral hazard, and could therefore increase the overall stability of the Eurozone.


Bordo, M D and F E Kydland (1995), "The gold standard as a rule: An essay in exploration", Explorations in Economic History 32(4): 423-464.

Mitchener, K J, and G Pina (2016), "Pegxit Pressure: Evidence from the Classical Gold Standard", CEPR Discussion Paper 11640 (updated 2017). 

Mitchener, K J, and M D Weidenmier (2015), "Was the Classical Gold Standard Credible on the Periphery? Evidence from Currency Risk", The Journal of Economic History 75(2): 479-511.

Obstfeld, M, and K Rogoff (1995), "The Mirage of Fixed Exchange Rates", Journal of Economic Perspectives 9(4): 73-96.

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