Exchange Rate Policy and LDC Foreign Borrowing∗

Samir Jahjah, Bin Wei, Vivian Zhanwei Yue†

July 2010

Abstract
This paper empirically analyzes how the exchange rate policy affects the issuing and pricing
of international bonds issued by less developed countries (LDCs). We measure an exchange
rate policy by the de facto exchange rate regime and the real exchange rate overvaluation.
We find that countries with a less flexible exchange rate regime are less likely to issue bonds
and pay higher spreads. Furthermore, we find that the real exchange rate overvaluation
significantly increases the bond spread and the bond issuance probability. Moreover, such
effects of the real exchange rate overvaluation tend to be magnified for countries with a
fixed exchange rate regime.

Keywords: Sovereign Credit Spread, Exchange Rate Regime, Overvaluation, Debt Crisis
JEL Classifications: E58, F31, F33, F34

∗
We are very grateful to two anonymous referees and Pok-sang Lam (the editor) for offering many
insightful comments and suggestions that have improved the paper immensely. We would also like to
thank Frank Diebold, Mark Gertler, and Martin Uribe, and the participants at the IMF Institute Seminar
for their comments. We thank Carmen Reinhart for providing us with the data on crises. This paper was
previously titled “Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries.” The authors
are responsible for all errors and omissions. The views expressed in this paper are those of the authors and
do not necessarily represent those of the IMF or IMF policy.
†
Jahjah is at the International Monetary Fund, 700 19th Street, N.W., Washington, D.C. 20431. Email:
sjahjah@imf.org. Wei is at the Department of Economics and Finance, Baruch College, CUNY, 55 Lexington
Avenue, New York, NY 10010. Email: bin.wei@baruch.cuny.edu. Yue is at the Department of Economics,
New York University, 19 West 4th Street, New York, NY 10012. Email: zy3@nyu.edu.

1
1 Introduction

The recent turmoil in the Euro zone has disturbed the economies from Greece to Italy to
emerging European countries and raises the wide-spread concerns over the sovereign default
and Euro depreciation. Turning our attention to developing countries and historical data,
we can find that the relation between the exchange rate arrangement and debt management
has for long been an important policy issue for developing countries. However, the active
policy debate on exchange rate policy and country risk has yet to be studied formally in the
academic literature. The goal of our paper is to empirically examine how the exchange rate
policy affects the issuing and pricing of foreign debt for less developed countries (LDCs).
Developing countries typically have a large amount of debt denominated in foreign
currency. Due to the risk of default,1 developing countries pay a sizable default risk premium
on their foreign debt. When the foreign debt is denominated in foreign currency, a weaker
local currency can exacerbate debt-service difficulties through the balance-sheet effect and
affect the country spread. Hence, the exchange rate management plays an important role
for developing countries’ foreign debt financing. At the same time, the choice of exchange
rate regime remains an elusive part of macroeconomic policy. In this paper we analyze the
impact of the exchange rate policy on foreign borrowing using the primary bond market
data on 42 developing countries. Our main methodology is to estimate a Heckman’s sample
selection model (see Heckman (1979)). In the empirical analysis, we draw on the findings
in the literature to obtain a reasonable set of control variables and include the measures
of exchange rate policy as the explanatory variables of bond issuing probability and bond
spread. We examine the effects of exchange rate policy on the issuing and the pricing of
international bonds by developing countries.
The first measure of a country’s exchange rate policy is its exchange rate regime. It
remains as an open question that how the choice of an exchange rate regime impacts a
country’s foreign debt borrowing. Firstly, there are virtually no comprehensive empirical

1
Reinhart and Rogoff (2008) document 71 default episodes for developing countries since 1975 to 2006.
They also provide a “panoramic” analysis of the history of financial crises dating from England’s fourteenth-
century default to the current United States sub-prime financial crisis.

2
studies on this question.2 Secondly, whether a country issues a bond and how the bond is
subsequently priced are presumably affected by the country’s overall economic performance.
However, the economic literature does not provide unambiguous implications as to which
exchange rate arrangement promotes a country’s economic performance. The impact of
exchange rate regime on the economic performance is probably one of the most controversial
topics in macroeconomic policy.
Supporters of a flexible exchange rate system argue that countries with hard-pegged
currencies are more vulnerable to real shocks, which may adversely affect growth and macro
stability. More flexible arrangements can better accommodate shocks and thus reduce the
uncertainty in the economy.3 Based on this argument, a fixed exchange rate regime results
in higher default risk in the context of foreign borrowing. Moreover, by eliminating the
monetary policy as a viable policy instrument, hard pegs may force the government to
increase its external liabilities, resulting in higher default risk. Gertler, Gilchrist, and
Natalucci (2007) show that fixed exchange rates exacerbate financial crises by tieing the
hands of the monetary authorities in a financial accelerator framework.4
On the other hand, supporters of a fixed exchange rate regime argue that this type of
exchange rate arrangement provides policy credibility. For example, pegging the exchange
rate may help to impose fiscal discipline on the government.5 The disciplining effect of a
peg may lead to a reduction in the country risk. Arellano and Heathcote (2010) specifically
show that countries with dollarization face a more favorable borrowing environment because
without the monetary policy instrument, these countries value their access to the foreign

2
Obstfeld and Taylor (2003) study the impact of gold standard on country borrowing spreads on the
London bond market from the 1870s to the 1930s. Arellano and Heathcote (2010) include a cross-country
regression of sovereign credit ratings on the exchange rate volatility from 1985-2000, while they focus on the
effect of dollarization on sovereign debt in their theoretical analysis.
3
Edwards and Sturzenegger (2005) and Broda (2004) provide some empirical evidence that the terms
of trade shocks have a larger effect on economic performance in countries with more rigid exchange rate
regimes, than in countries with a flexible exchange rate regime.
4
Gertler, Gilchrist, and Natalucci (2007) focus on the Korean experience during the 1997-1998 financial
crisis and quantitatively examine how defending an exchange rate peg may reinforce the financial crisis.
Cespedes, Chang and Velasco (2004) also discuss the role of exchange rate regimes on excerbating financial
crisis in a qualitative analysis.
5
Giavazzi and Pagano (1988) show that a government may choose a particular exchange rate arrangement
to buy itself a reputation.

3
capital market more and are thus less likely to default. Moreover, a fixed exchange rate
system is believed by its supporters to foster a more stable environment and faster economic
growth. As argued in the literature, hard pegs can lead to lower interest rates and eliminate
exchange rate volatility, which stimulates investment and international trade, resulting in
faster growth.6 These growth-enhancing effects suggest that a fixed exchange rate regime
may be advantageous to a country’s foreign borrowing.
As the preceding discussion suggests, determining how a country’s exchange rate regime
affects its default probability and its foreign debt borrowing is ultimately an empirical issue
that can only be elucidated by analyzing the historical evidence.
Our first main finding is that the choice of exchange rate regime has a significant impact
on LDC foreign borrowing. Specifically, the less flexible a country’s exchange rate regime
is, it is less likely to issue foreign bonds and pays higher spreads. The decrease in the
bond issuance probability and the increase in the bond credit spread are both statistically
and economically significant. The marginal effect from changing a free floating exchange
rate regime to an intermediate one on the bond spread is to reduce the bond issuance
probability by about 3% and increase the spread by 43 basis points, and further changing
from the intermediate one to a fixed one decreases the probability by 1.6% and increases the
spread by an additional amount of 89 basis points. Our results therefore unambiguously
point to the adverse effect of a fixed exchange rate regime on a country’s foreign debt
financing, which is consistent with the conclusions from Gertler et al. (2007).
Another measure of exchange rate policy is the real exchange rate overvaluation. Real
exchange rate as a key relative price is important for the policy analysis because of its
implications for international trade and capital flows.7 In our analysis, we use real exchange
rate overvaluation as a second measure of exchange rate policy, which is defined as the
difference between the actual real exchange rate and its long-run equilibrium level. A
country’s debt policy may respond to its real exchange rate, especially when the currency

6
See Dornbusch (2001), Rose (2000), and Rose and van Wincoop (2001). Please see Levy-Yeyati and
Stuzenegger (2003) for an extensive review.
7
For example, the average level of real exchange rate matters for export-led growth for developing coun-
tries, and real exchange rate is a key indicator of incipient currency crises. See Eichengreen (2008).

4
is misaligned, for the following reasons. First, an overvalued currency reduces a country’s
trade competitiveness and weakens the macroeconomic fundamentals.8 As a result, the
default risk may increase, so are the borrowing costs (See Eaton and Gersovitz (1981)).
Second, exchange rate overvaluation has been found to be a main cause of currency crises.
A vast literature finds that the real exchange rate is overvalued during the period prior
to devaluations or crises.9 When a country borrows in foreign currency, its debt liability
becomes more costly to serve following the devaluation and hence the default risk rises.10
Lastly, the choice of exchange rate regime and real exchange rate overvaluation may have
a joint impact on sovereign debt market.11 An inflexible exchange rate regime compounds
the adverse effect of a real overvaluation because the cost of correcting the exchange rate
misalignment is higher for a country with a fixed exchange rate. The overvaluation has a
larger and more persistent impact on the economy for a hard pegger. Therefore, a country
with an inflexible exchange rate regime is more likely to default on its debt when its currency
is overvalued.
Our second main finding is that real exchange rate overvaluation significantly increases
foreign bond issuing probability and generally raises bond spreads for developing countries.
The magnitude of this effect differs across exchange rate regimes. In our empirical analysis,
we use three measures of real exchange rate overvaluation to examine its impact on foreign
borrowing. We find that for all three measures the interaction between a fixed exchange rate
regime and real exchange rate overvaluation has the biggest effect on the supply and pricing
of international bonds. Quantitatively we find that a one-standard-deviation increase of
real exchange rate overvaluation, measured by the percentage deviation of the real effective
exchange rate from its ten year average, increases the spread by 86 basis points for a country

8
Aghion et al. (2009) find that countries suffering from real overvaluation experience slower productivity
growth. Eichengreen (2008) contains a survey of the literature that document how a competitive real
exchange rate fosters growth and real overvaluation slows growth for developing countries.
9
See Dornbusch et al. (1995), Edwards (1989), Eichengreen et al. (1995, 1996), Kaminsky et al. (1998),
and Goldfajn and Valdes (1999).
10
Schneider and Tornell (2004) find that balance-of-payments crises are preceded by lending booms and
real appreciation in a model with self-fulfilling crises and balance sheet effects.
11
Jahjah and Montiel (2003) find that a hard peg increases default likelihood, especially in cases of large
exchange rate overvaluation.

5
with a fixed exchange rate regime, while the same increase only increases the spread by 33
and 29 basis points if the country is in an intermediate and floating exchange rate regime.
The same pattern persists when the other two measures are used.
Our main results hold in a variety of robustness tests, including allowing for alternative
control variables and correcting for endogeneity. To address the endogeneity problem for
the exchange rate regime and real overvaluation, we conduct a multi-stage estimation of the
Heckman’s selection model and use clearly exogenous variables as instrumental variables for
the exchange rate regime and overvaluation. We find that controlling for the endogeneity
issue does not change our results qualitatively. These tests make us confident that our
empirical results indeed capture the impact of exchange rate policy on foreign debt for
emerging countries.
Linking explicitly the exchange rate policy to bonds issuing and pricing is our main
contribution to the literature on sovereign default risk in emerging economies. Edwards
(1984), Cline (1995), Easton and Rockerbie (1999), and others investigate the determinants
of sovereign debt spreads in sovereign loans. Eichengreen and Mody (1998) and Kamin and
Kleist (1999) analyze bond spreads on primary market using data on international bonds
issued by developing countries. However, none of these empirical works incorporates the
impact of exchange rate policy on sovereign bonds pricing and issuing. Edwards (1984)
includes nominal exchange rate devaluation as one determinant of spreads, but the impact
of devaluation is not significant.
There are a few empirical analyses and event studies relating the exchange rate policy
to the country risk. Reinhart (2002) examines the linkage between default, currency crises,
and sovereign credit rating. She finds that defaults usually follow sharp devaluation or are
responses to speculative attacks on exchange rate arrangements. Powell and Sturzenegger
(2000) evaluate the relation between the elimination of currency risk through dollarization
and country risk. Yet their analysis is limited to countries that adopted the Dollar or Euro.
This paper is also related to the recent studies on the impact of exchange rate regime and
real exchange rate volatility. Levy-Yeyati and Sturzenegger (2003) study the relationship
between exchange rate regime and growth, and find the less flexible exchange rate regimes

6
are associated with slower growth. Broda (2004) find that countries with flexible regimes
are able to buffer terms-of-trade shocks better than those with fixed regimes. Aghion et al.
(2009) show some empirical evidence that real exchange rate volatility can affect the long-
term productivity growth rate, and find that the effect depends critically on a country’s
level of financial development. Our work assesses the impact of exchange rate policy on
sovereign default risk which is another important dimension for developing countries.
In the remainder of the paper, we describe the dataset and our methodology. The main
empirical analysis is carried out in Section 3. In Section 4 we summarize the paper and
conclude.

2 Data and Methodology

2.1 The Data

Bond data come from Capital Data’s Bondware and contain the detailed terms of bonds
issued in the primary market by 42 developing countries between January 1990 and De-
cember 2006.12 The Bondware dataset contains information on the launch spreads, launch
dates of international bonds issued in dollars by developing countries. The launch spread is
defined as the difference between the yields on a bond issued and the U.S. Treasury bond
with comparable maturity. We use the Bondware data at the individual bond level at the
monthly frequency. There are totally 2,653 bond issues in the sample. The list of countries
and the total number of bond issues in the sample period are reported in Table 1.

Insert Table 1 Here

We work with the primary bond market data because, to the best of our knowledge,
there is no secondary market bond dataset that covers a large sample of countries.13 In

12
There are initially 66 countries covered in the Capital Data’s Bondware data during the sample period.
Among them, four countries are dropped because they have no RR regime classification and twenty countries
are further dropped from the sample due to the unavailability of some explanatory variables.
13
J.P. Morgan’s EMBI global and EMBI+ are the secondary market datasets constructed for 23 countries
starting in 1994 or later depending on the countries.

7
addition, using the primary market data allows us to analyze both the issuing and the
pricing decisions for developing countries.
We use the de facto exchange rate regime as a key explanatory variable in our empirical
analysis. We employ the monthly classification of the de facto exchange rate regimes con-
structed by Reinhart and Rogoff (2002) (RR) who classify the exchange rate arrangements
based on the official exchange rate and parallel market rates. We use the de facto exchange
rate regime as opposed to the de jure exchange rate regime because the latter is not a good
measure of a country’s exchange rate arrangement.14 In most of the analysis, we aggregate
the RR exchange rate classification into three groups: fixed, intermediate, and free floating
regimes.15 The aggregation of exchange rate regimes is summarized in Table 2.16 In the
empirical analysis, we use the exchange rate regime dummies of FIX (fixed regimes), INT
(intermediate regimes), and FLOAT (free floating regimes). FIX (resp., INT or FLOAT)
takes the value 1 when the country is operating a fixed exchange rate regime (resp., an
intermediate or free floating regime) and 0 otherwise.

Insert Table 2 Here

Next, we compute the real exchange rate overvaluation using three measures.17 The
first two measures of exchange rate overvaluation are computed using the monthly real
effective exchange rates (REER) from the IMF Information Notice System. The REER is
a trade-weighted index of multilateral real rates measured by units of foreign goods per
domestic goods. The first measure of the real exchange rate overvaluation is the percentage

14
A country may in practice deviate from its announced exchange rate regime. Calvo and Reinhart (2002)
and Alesina and Wagner (2003) study the reasons why countries do not follow their de jure exchange rate
regimes.
15
We also conducted the empirical analysis using the exchange rate regimes grouped into four classes:
hard peg, conventional peg, intermediate and free floating or grouped into two classes: fixed and floating.
The different grouping methods do not change the results. The estimation is available upon request.
16
Two adjustments are made to the RR classification. A free falling regime is defined as one with a
monthly inflation rate greater than 40%. Because the inflation is one regressor in our empirical analysis,
we categorize this group using the secondary classification. We discard the observations in the dual-market
regime because no secondary classification is available. Our empirical analysis is robust to the exclusion of
these two groups.
17
As reported in Hinkle and Montiel (1999), there is no universal method to compute the exchange rate
misalignment or real exchange rate overvalution.

8
deviation of the REER from its ten year average (ROV1). The second measure is the
percentage change in the REER over the last five years (ROV2).18 The third measure is the
deviation from a predicted level of the real exchange rate (ROV3). The predicted level of
the real exchange rate is based on the equilibrium concept of Purchasing Power Parity and
is adjusted from differences in the relative price of non tradeables to tradeables attributed
to differences in factor endowments (i.e., the “Balassa-Samuelson” effect).19 The PPP real
exchange rate is from the Penn World Table (PWT). Following Dollar (1992) and Aghion
et al. (2009), we first perform a pooled OLS regression to obtain the predicted value as
an estimate of the equilibrium value of the real exchange rate, and then take the difference
between the actual real exchange rate and its predicted value from the OLS regression as
the third measure of real exchange rate overvaluation. In the pooled OLS regression, income
per capita relative to that of the United States and geographical and year dummies are used
as proxies for factor endowments.
We draw on the findings in the literature to obtain a reasonable set of control variables
that have been found to be important determinants of bond spreads.20 We use real interest
rates on ten-year U.S. Treasury bonds (USRATE) and the spreads on the U.S. high yield
corporate bonds (HYD) as proxies for the global economic condition. For the domestic
economic indicators, we use the GDP growth rate (GDPGR), the GDP per capita in U.S.
dollars (GDPPC), the current account as a ratio of GDP (CA2GDP), and inflation (INF).
We also include some liquidity and solvency variables, such as, the ratio of debt to GNP
(DT2GNP), the ratio of debt service to exports (DS2EX), and the ratio of short-term debt to
total debt (SHORTDT). In addition, we employ the regional dummies for countries in Africa
(AFRI) and the Latin America (LAT). Our objective is to use a reasonable set of controls to
test whether the exchange rate policy has a significant impact on the issuing and pricing of

18
These two measures are also used in Frankel and Saravelos (2010).
19
We also measure the exchange rate overvaluation using the difference between log of the real exchange
rate and its H-P trend. The results are robust, but not reported in the paper. They are available upon
request.
20
Our baseline specification follows closely those reported in Edwards (1984), Eichengreen and Mody
(1995), Dell’Ariccia et al. (2002), etc. We also include control variables that are not in these earlier studies
but have been extensively discussed as important determinants of international bond spread.

9
international bonds for emerging markets. We collect data on the macroeconomic indicators,
and country-issuer characteristics from the IMF’s International Financial Statistics (IFS),
the World Bank’s World Development Indicators (WDI), the Penn World Table (PWT),
the Global Development Finance (GDF) and the Federal Reserve Board. The detailed
description of the variables and their sources is are Table A1 in the Appendix.

2.2 The Econometric Methodology

This subsection describes the main econometric model that is based on the Heckman’s
sample selection model. The credit spread of an international bond issued by a developing
country is a measure of its default risk. As in Eaton and Gersovitz (1981), Edwards (1984)
and the subsequent studies in the literature, we assume that the logarithm of the spread is
a linear function of some explanatory variables, X, that affect the default risk. Formally,

log (SPREAD) = αX + u, (1)

where u is a random error term. The explanatory variables are bond characteristics, ex-
change rate regime dummies, real exchange rate overvaluation measures, and control vari-
ables that summarize the global economic conditions and country characteristics.
Because we only observe the bond spread when a bond is issued, a sample selection
problem arises. When no spread is observed for a country in a given year, we may assume
that the missing spreads are random occurrences and ignore them, but if the gaps occur
according to some unknown but systematic selection method, estimating Equation (1) alone
leads to biased and inefficient estimates. For example, a country may be excluded from the
credit market if its perceived probability of default exceeds a given level, i.e., it reaches
a “credit-ceiling”.21 Conversely, a country tends to issue international bonds when the
borrowing conditions are favorable and its financing need is high. To deal with the sample
selection problem, we create a binary variable for the bond issuance: BI equals 1 when we

21
See Eaton and Gersovitz (1981), Sachs and Cohen (1982), and Sachs (1983).

10
observe a nonzero spread for a country at time t, and zero otherwise. We assume

BI = 1{βZ+v>0}, (2)

where Z is a set of observed variables that explain the issuing decision of a country in
a given month and v is a random error term. We can think of βZ + v as the difference
between benefit and cost from issuing bonds, and Equation (2) indicates that a bond issue
is observed if and only if the benefit exceeds the cost.
The spread equation (1) and the issuance equation (2) consist of a standard Heckman’s
(1979) sample selection model. We can estimate Equation (2) as a probit model to get the
probability of issuing a bond. Estimating the probit model requires information on those
who did not issue bonds. To address this problem, we record a zero for each month and
country where no bond issuance is observed. The model can be identified by the exclusion
requirement for the Heckman selection model. In our empirical analysis, the vector of
explanatory variable Z in the issuance equation (2) includes all the variables in X as well
as one exclusion variable that is used for identification. For the exclusion variable, we use a
January dummy in the bond issuance equation. The logic behind using the January dummy
as the exclusion variable is the following. Countries are less likely to issue new bonds in
January because of the holiday seasons for the major international financial centers. On the
other hand, the January dummy should not enter the spread equation (1) since whether or
not the bonds are issued in January should not change the evaluation of the default risk.
We use the maximum likelihood method to estimate Equations (1) and (2) jointly un-
der the assumption that the error terms, u and v, follow a bivariate normal distribution.
The maximum likelihood method obtains the efficient estimates under a correctly specified
model. We also check the results by estimating the model using the Heckman’s two-stage
method.22 The two procedures give similar results.

22
The two-stage estimation method of the Heckman’s model is implemented as follows. In the first stage,
Equation (2) is estimated as a Probit model to get the probability of a bond issue. Then, the value of Mill’s
ratio (reflecting the conditional probability of the observation being in the observed sample) is incorporated
in an OLS regression of (2) using the observed log (spread) only.

11
 In the empirical analysis, we also quantify the impact of exchange rate regime and
real overvaluation on the issuing and pricing of the international bonds by calculating the
marginal effects. The marginal effects consist of two components. There is a direct effect on
the mean of log (SP READ), but also an indirect effect because the exchange rate regime
or real overvaluation affects the bond issuing decision and hence influences log (SP READ)
indirectly.
First, the marginal effect on the bond spread of changing a country’s exchange rate
regime from FLOAT to INT is given by23

E [log (SP READ) |INT − log (SP READ) |F LOAT |BI = 1 ] (4)
" Ã ! Ã !#
−βZ (0,1) −βZ (0,0)
= αINT + ρσ u λ −λ .
σv σv

where αF IX is the coefficient of F IX in Equation (1) and λ (x) ≡ φ (x) /Φ (x) is the inverse
Mill’s ratio in which φ and Φ are, respectively, the probability density function (PDF)
and the cumulative distribution function (CDF) of a standard normal random variable.
Let Z (0,0) be the vector of explanatory variables in the bond issuance equation (2) with
(F IX, IN T ) = (0, 0) and all the other variables at their mean values. Z (0,1) or Z (1,0) is
similarly defined except that (F IX, IN T ) is equal to (0, 1) or (1, 0), respectively.
Similarly, if the exchange rate regime changes from INT to FIX, then the marginal effect
is given by

E [log (SP READ) |F IX − log (SP READ) |INT |BI = 1 ] (5)

" Ã ! Ã !#
−βZ (1,0) −βZ (0,1)
= αF IX − αINT + ρσ u λ −λ
σv σv

where αINT is the coefficient of IN T in Equation (1).

23
We derive the marginal effects in Equations (4)-(6) by following Greene (2002). The key is to derive the
conditional expectation of log (SP READ) conditioning on the spread being observed, which is given by

E [log (SP READ) |BI = 1 ] = αX + ρσu λ (−βZ/σv ) . (3)

12
 Lastly, the marginal effect of ROV evaluated at the sample mean in the observed sample
is given by
µ ¶
∂E [log (SP READ) |BI = 1 ] −βZ
= αROV − γ ROV ρσ u δ (6)
∂ROV σv

where αROV and β ROV denote the coefficients of real exchange rate overvaluation (ROV)
in Equations (1)-(2), δ (x) ≡ (λ (x))2 − xλ (x), and Z is the vector of explanatory variables
in the bond issuance equation (2). The marginal effect of ROV in a given exchange rate
regime is similarly defined.

3 Empirical Analysis

In this section we empirically investigate the effects of the choice of the exchange rate
regime (FIX, INT, or FLOAT) and the real exchange rate overvaluation (ROV1-ROV3) on
the issuing and the pricing of international bonds by developing countries. We first report
the empirical results in the baseline specification, and then report in the next section the
results of various robustness tests including the endogeneity tests.

3.1 Empirical Results

We explore the effects of the exchange rate regimes and real exchange rates on LDC for-
eign borrowing. Because we do not intend to reexamine results profusely analyzed in the
empirical sovereign bond spread literature, we choose a relatively noncontroversial set of
control variables.24 We then add the exchange rate regime dummies, FIX (fixed exchange
rates), and INT (intermediates), as well as the measures of real exchange rate overvaluation
(ROV1-ROV3), in the empirical analysis.
We first estimate the baseline model in which we include the regime dummies (FIX and
INT) together with a set of explanatory variables. The estimation results are presented in
Table 3. Ignoring the sample selection issue, we first run a pooled OLS regression using the

24
See Eichengreen and Mody (1998), Edwards (1984).

13
bond spread as the dependent variable. The regression results are reported in the second
column of Table 3. We then take into account the sample selection issue and estimate
the Heckman’s model, as specified in Equations 1 and 2, using the full sample including
the month-country pairs for which there were no bonds issued. The maximum likelihood
estimation results are reported in the last two columns of Table 3.

Insert Table 3 Here

As can be seen, the control variables behave largely as expected. In addition, most of
them have the similar coefficients in both the OLS regression and the Heckman’s sample
selection model. First, the coefficients on AMOUNT and ISSUES are significantly positive
in the spread equation and significantly negative in the issuance equation. As analyzed in
Eichengreen and Mody (1998), these variables with the coefficients working in offsetting
directions can be interpreted as proxies for the supply of bonds. Countries that issued a
large number of bonds in a big amount last year have accumulated an unsatisfied appetite
for borrowing and tend to supply additional new issues, resulting in an outward shift in the
bond supply. Hence a higher borrowing in the past reduces the price of their bonds and
increases the spread.
Regarding the global economic condition, a higher U.S. real interest rate (USRATE)
suppresses the supply of bonds by developing countries due to the higher financing costs
for them, and it has an insignificant and negative impact on the risk premium.25 A higher
spread on the high-yield corporate bonds (HYD) significantly reduces the issuance prob-
ability and tends to increase the bond spread. This result confirms the observation that
the market requires a similar risk premium on the high-yield corporate bonds and emerging
market country bonds.
Regarding the issuing country’s macroeconomic variables, a high growth rate of per
capita GDP (GDPGR) or a high level of GDP per capita (GDPPC) enhances the market
demand for international bonds, which increases the issuance probability and decreases the

25
Eichengreen and Moday (1998), Kamin and Keist (1998), and Uribe and Yue (2006) also find that the
US real interest rates reduces the comtemporaneous country spread.

14
spread. These variables are proxies for the demand for bonds from international investors
because their coefficients work in reinforcing directions in the issuance and spread equations.
The debt to GNP ratio (DT2GNP), which is shown to be another proxy for the demand,
works in the opposite way. Specifically, a higher debt to GNP ratio diminishes the market
demand, reducing the probability of a bond issue, driving down the price and increasing the
spread. The other two indices of a country’s external debt (DS2EX and SHORTDT) do not
significantly affect the bond spread, but increase the bond issuance probability significantly,
reflecting a borrowing country’s need for liquidity. A higher inflation on the other hand
significantly increases the bond spread, but does not affect the likelihood of bond issuance.26
Lastly, we find that countries that have a high ratio of current account to GDP (CA2GDP)
tends to supply a high volume of bonds. The prices of their issues are thus driven down
and the spreads are driven up.
Finally, the regional dummies for Africa or Latin America have positive (negative) co-
efficients in the spread (issuance) equation. The dummy for the January effect significantly
reduces the probability of issuing bonds, serving as a valid exclusion variable. The corre-
lation between the error terms in the issuance and spread equations is equal to -0.145 and
significantly negative. The negative correlation implies that some unobserved factors that
lead to a higher issuance probability also lower the bond spread. Thus these factors should
also be interpreted as unobserved determinants of demand.
Let us now focus on the impact of the exchange rate regime on the LDC borrowing.
We first discuss the estimation results of the Heckman’s sample selection model in the last
two columns of Table 3 regarding the role of exchange rate regime. We can see from the
table that choosing a less flexible exchange rate regime (INT or FIX) decreases the bond
issuance probability and increases the bond spread. That is, it is both more difficult and
more costly to borrow for countries in intermediate or fix regimes, as if these countries were
penalized for not choosing a more flexible exchange rate regime. Further, the estimated
coefficient on FIX is significantly higher (lower) than the coefficient on INT in the spread

26
Reinhart and Rogoff (2010) document the high correlation between high inflation and the occurrence of
debt crisis using data that covers a period of over 200 years.

15
(issuance) equation, implying a monotone relation between the flexibility of the exchange
rate arrangement and the bond spread. The results indicate that a country’s exchange
rate regime impacts foreign borrowing by shifting the demand curve of its international
bonds. Specifically, the market is less inclined to demand the bonds of a country that has
a less flexible exchange rate regime. As a result, it is less likely to observe an issue and the
corresponding decline in demand increases the spreads on observed issues.
The impact of the exchange rate regime is not only statistically significant, but also eco-
nomically significant. To see the latter, we quantify the marginal effect of making a country’s
exchange rate regime less flexible on the bond spread as shown in Equations (4)-(5). In the
data, the average spread among the floaters is 319 basis points. From the OLS regression
results as in the second column in Table 3, we can see that changing from a floating ex-
change rate regime to an intermediate one increases the spread by 319*(exp(0.137)-1)=46.7
basis points, and changing from intermediate to fixed increases the spread by an additional
amount of 92.5 (=319*(exp(0.392-0.137)-1)) basis points. The OLS regression ignores the
potential sample selection bias. After we take into account the sample selection issue by
using the Heckman’s model, the marginal effect from converting a floating exchange rate
regime to an intermediate one is 43 basis points, while the marginal effect from converting
the intermediate exchange rate regime further to a fixed one increases the spread by an
additional amount of 89 basis points. So the direct use of the OLS regression without ac-
counting for the potential sample selection bias tends to slightly overestimate the impact.
Using the estimation results of the issuance equation in the last column of Table 3, we com-
pute the marginal effect from a change in the exchange rate regime on the bond issuance
probability. We find that a country in an intermediate exchange rate regime would be 1.6%
less likely to issue a bond if its exchange rate regime had become a fixed one, but would
be about 3% more likely to issue a bond if it had become a floater. Overall, we find that
countries with a less flexible exchange rate regime issue less debt and pay a significantly
higher bond spread as a result of less demand for the bonds they issued in the international
market.
Next, we consider the other measure of exchange rate policy in our paper, that is, real

16
exchange rate overvaluation. To investigate its impact on the bond issuance and pricing,
we estimate the Heckman’s model in which we include measures of real exchange rate
overvaluation as well as their interaction with the exchange rate regime. As stated in Section
2.1, we use three measures of real exchange rate overvaluation, for which the estimation
results are reported in Tables 4A-4C, respectively. Each table contains three columns.
We first use the real exchange rate overvaluation alone as an explanatory variable in the
Heckman selection model and report the result in column (I). Column (II) shows that the
impact of the real exchange rate overvaluation and the exchange rate regime when both
of them are included. Lastly, to better identify their joint impact, we further include the
interaction terms between them (Column III), which are the products of the real exchange
rate overvaluation and the three exchange rate dummies. By construction these interaction
terms sum up to the measure of the real exchange rate overvaluation.

Insert Tables 4A-4C Here

We find that the real exchange rate overvaluation significantly increases both the bond
spread and the bond issuance probability. This result is significant and holds for all three
measures of real exchange rate overvaluation (ROV1-ROV3). Firstly, an overvalued cur-
rency makes a country’s export less competitive. Real exchange rate overvaluation is found
to be usually associated with low economic growth and loss of government revenue.27 Hence,
the borrowing country may experience greater difficulty in servicing its debt. When the gain
from correcting the exchange rate misalignment is high and there is little cost associated
with default, default probability increases significantly. Secondly, a real exchange rate over-
valuation is highly likely to be corrected in the form of a currency devaluation or crisis,
which increases a country’s default risk due to the currency mismatch of the balance sheet.
Powell and Sturzenegger (2000) for example find a strong link between devaluation and
default risk. Lastly, a country experiencing real overvaluation tends to borrow more be-
cause overvaluation may signal good times (e.g., due to benign real shocks) and developing

27
Prasad et al (2006), Eichengreen (2008), Aghion et al. (2009) study the impact of real exchange rate
overvaluation on the economic growth.

17
countries typically borrow procyclically.28 Hence, the country supplies more bonds in the
market, which in turn drives down the price and results in a higher bond spread. In sum,
a larger real exchange rate overvaluation may increase the bond spread and bond issuance
probability through these three channels.
Based on columns (I) in Tables 4A-4C, we compute the marginal effect of real exchange
rate overvaluation on the spread as specified in Equation (6). We find that if the real ex-
change rate becomes more overvalued by one sample standard deviation of the overvaluation
measure, the average bond spread increases by 47.5, 27.6, and 20.5 basis points when the
real exchange rate overvaluation is measured by ROV1-ROV3, respectively.
When both the real exchange rate overvaluation and the exchange rate regimes are used
in the regression, from columns (II) of Tables 4A-4C the impacts of the real exchange rate
overvaluation and the exchange rate regime remain significant. A fixed or intermediate
exchange rate regime has an independent positive effect on the bond spread and an inde-
pendent negative effect on the bond issuance probability. The coefficients on the regime
dummies are slightly lower, but remain to be a monotone function of the exchange rate
flexibility.
Lastly, we investigate the combined effect of real exchange rate overvaluation and ex-
change rate regime. From columns (III) of Tables 4A-4C, we find that among the three
interaction terms, ROV × F IX has the largest and significantly positive coefficients in the
issuance and spread equations (except that the coefficient becomes insignificant in the is-
suance equation for ROV2). This result suggests that the effects of the real exchange rate
overvaluation tend to be magnified for countries with a fixed exchange rate regime. We
can think of two possible explanations for these results. First, when a country has a hard
peg or limited exchange rate flexibility, the real overvaluation tends to be persistent.29 As
a result, servicing foreign debt can be less costly in domestic currency. Hence, countries
with a less flexible exchange rate arrangement are more likely to borrow in periods of real

28
Arellano (2008), Aguiar and Gopinath (2006), and Yue (2010) document and show the procyclicality of
sovereign borrowing in a Eaton-Gersotivz framework. We thank a referee for suggsting this explanation.
29
Edwards (1988) finds that the autonomous forces that move the real exchange rate back to equilibrium
operate very slowly, keeping the country out of equlibrium for a long time.

18
overvaluation. The increase in the supply of bonds from countries with a fixed exchange
rate regime and real overvaluation drives down the bond price and results in a higher bond
spread. Second, when a country is in a hard-peg regime, the overvaluation has a larger
and more persistent adverse impact on the economy.30 Debt becomes rapidly unsustainable
and the probability of default increases. By contrast, for a floater, owing to the exchange
rate flexibility, nominal devaluation can greatly help to speed up the real exchange rate
realignment. Therefore, real exchange rate overvaluation has the least impact on the bond
spread for countries with a free-floating regime.
We also assess the economic significance of the combined effect by computing the mar-
ginal effect. For example, when the exchange rate overvaluation is measured using ROV1
(see column (III) of Table 4A), we find that a one-standard-deviation increase of ROV1
increases the spread by 86 basis points for a country with a fixed exchange rate regime,
while the same increase of ROV1 only increases the spread by 33 and 29 basis points if the
country is in an intermediate and floating exchange rate regime. The same pattern persists
when the other two measures (ROV2 and ROV3) are used.
In summary, we find that a real exchange rate overvaluation increases both the bond
issuance probability and the bond spread, and such effect takes place mainly when the
country has a fixed exchange rate regime.

4 Robustness

In this section we summarize the various robustness checks that we run to address some
of the concerns that our findings may give rise to. In particular, we discuss: (a) the ro-
bustness of our main findings by including more macroeconomic control variables and the
roles played by these additional variables in affecting the bond issuance/pricing decisions;
(b) the endogeneity problem associated with exchange rate regime and real exchange rate
overvaluation.

30
Edwards and Levy-Yeyati (2005) argue that the adjustment in equilibrium real exchange rate upon a
real external shock takes longer in countries with a fixed exchange rate.

19
 In the first robustness check, we add more macroeconomic control variables. We include
the debt crisis dummy (DCRISIS), debt rescheduling dummy (DRES), and total reserve
to GNI (RES2GNI) as additional regressors. Because of the data availability, there are 40
countries left in the sample when these controls are used. The debt crisis dataset is taken
from Reinhart and Rogoff (2008). The debt rescheduling dummy, constructed from GDF,
is equal to unity if there is a non-zero amount of debt rescheduled for a country and zero
otherwise.
The results are summarized in columns (I) and (II) in Table 5A. In both the OLS
regression and the Heckman’s model, the dummy for debt rescheduling (DRES) enters the
spread equation significantly and positively. It also picks up the effect from debt crises,
making the debt crisis dummy (DCRISIS) insignificant. Further, although the coefficients
of the dummies for both debt rescheduling and debt crises are insignificant in the issuance
equation (see column (II) in Table 5A), they are positive, implying that a country that
is in crisis or is experiencing debt rescheduling finds it more difficult to issue new bonds.
Moreover, such a country is considered by investors to have higher default probability, and
thus the country has to provide a higher spread on its bond if it chooses to issue one. The
ratio of total reserve to GNI (RES2GNI) decreases both bond spreads and the likelihood of
bond issuance significantly. It suggests that a country that has relatively large reserve tends
to supply a low volume of bonds and consequently the prices of their issues are driven up
and the spreads are driven down. Lastly, from the comparison between Table 5A and Table
3, we still find that the exchange rate regime affects the issuing and pricing of international
bonds after we control for debt crisis, rescheduling, and the ratio of reserve to GNI.
In the second robustness check, we deal with the concerns that some variables, such as
the exchange rate regime and real exchange rate overvaluation, may be endogenous. In the
previous analysis, we treat all the variables as strictly exogenous for both bond issuance
and spread determination. But one concern is that the relation we find in the data may
be caused by the reversed causality. In particular, the choice of exchange rate regime may
be a response to a debt crisis or a mechanism to lower borrowing costs. In the subsequent
analysis, we deal with this potential endogeneity problem.

20
 As a first attempt at the endogeneity issue, we single out observations associated with
countries with de facto pegs throughout our sample period (FIXALL) by following Levy-
Yeyati and Sturzenegger (2003) and include the dummy, FIXALL, in the OLS regression and
the Heckman’s model (see columns (I) and (II) in Table 5A). As argued by these authors,
since this group of countries corresponds to economies within long-standing currency unions,
it seems reasonable to assume that the original regime choice is independent from their
growth performance and from the bond issuance/pricing decisions. As can be seen from
columns (I) and (II) in Table 5A, the positive (negative) impact of a fixed exchange rate
regime on the spread (the likelihood of bond issuance) is significant for this group of countries
relative to the rest of the countries in our sample. This presents initial evidence that the
main findings in our paper are not severely contaminated by the endogeneity problem.
We next correct for the endogeneity of the exchange rate regime and real exchange
rate overvaluation using a feasible generalized two-stage IV (2SIV) estimator and report
the regression results in column (III) of Table 5A and in Table 5B. To correct for the
endogeneity of the exchange rate regime, we first run a multivariate logit model of the
exchange rate regimes choice, R, which can take the value of FIX, INT or FLOAT. The
multinomial logit model assumes that the probability of one outcome can be expressed as
follows:

exp (Y β 1 )
Pr (R = F IX) =
1 + exp (Y β 1 ) + exp (Y β 2 )
exp (Y β 2 )
Pr (R = IN T ) =
1 + exp (Y β 1 ) + exp (Y β 2 )
1
Pr (R = F LOAT ) =
1 + exp (Y β 1 ) + exp (Y β 2 )

where Y is the vector of variables used to explain the choice of an exchange rate regime.
β’s are the associated coefficients. The relative probability of choosing FIX (INT) to the
FLOAT is exp (Yt β 1 ) (exp (Yt β 2 )).
Similarly, to deal with the potential endogeneity problem associated with real exchange
rate overvaluation, we run three OLS regressions on the variables Y to obtain the fitted
values for ROV1-ROV3, and then we use these fitted values as well as those for exchange rate

21
regime dummies that are obtained from the above multinomial logit regression to estimate
the Heckman’s sample selection model.
The key issue is to find suitable instrumental variables for the exchange rate regime and
the real overvaluation. For the exchange rate regime, following Levy-Yeyati and Sturzeneg-
ger (2003) we use the ratio of the country’s GDP over the U.S. GDP (SIZE), the geographical
area of the country (AREA), an island dummy (ISLAND), the ratio of reserve to monetary
base (RESBASE), and a regional exchange rate indicator (REGEXCH) that is equal to the
average exchange rate regime of the country’s neighbors defined as those under the same
IMF department. We also control for the potential endogeneity issue for the real overvalu-
ation. As in Prasad et al. (2006) and Eichengreen (2008), we use the share of working-age
persons in the population (WORKPOP) and a dummy variable for oil-exporting countries
(OILEX) as the instrumental variables for the real exchange rate overvaluation.
We use all the exogenous regressors in the baseline model and additional instrumental
variables in auxiliary regressions to obtain fitted values for the exchange rate regime and
overvaluation. The second and third columns in Table 5C report the result of the multino-
mial logit regression of the exchange rate regime over all the instruments. The coefficients
are interpreted as a variation in the relative probability of choosing one regime over a free-
floating regime. The last three columns show the estimates of the OLS regressions on the
different measures of real exchange rate overvaluation. Most variables are highly significant
and have the expected signs. On the choice of the exchange rate regime, smaller countries
tend to be more open and thus are more likely to choose a fixed exchange rate regime. A
high initial level of reserves helps a country to overcome the “fear of floating”. Finally, the
regional exchange rate indicator may indicate explicit or implicit exchange rate coordination
among neighboring countries.31 Regarding the OLS regressions for the real overvaluation,
a higher share of working-age population reduces the likelihood of real overvaluation.32

31
See Levy-Yeyati and Sturzenegger (2003) for more details on the multinomial logit model for the exchange
rate regime.
32
Prasad et al. (2006) argue that a rapidly growing labor force should lead to undervaluation due to the
pressure on policy makers to maintain a competitive real exchange rate in order to absorb additional workers
into employment. Eichengreen (2008) also documents a similar relation between the share of working age
population and real overvaluation.

22
Oil-exporting countries are more prone to overvaluation.

Insert Tables 5A-5C Here

From the multinomial logit model, we can estimate the predicted probabilities of choos-
ing a fixed or intermediate exchange rate regime. We use the predicted probabilities to
replace the corresponding regime dummies and estimate the Heckman’s model, as shown
in column (III) in Table 5A. A comparison of Table 3 and Table 5A shows that our main
findings hold after correcting for the endogeneity. The coefficients on FIX and INT are still
significantly positive in the spread equation and negative in the issuance equation. In gen-
eral, an inflexible exchange rate regime decreases bond issuance probability and increases
the bond spread, which is consistent with the results in the baseline empirical analysis.
The estimation results after the endogeneity correction for the real overvaluation are re-
ported in Table 5B. For the first two measures of the real overvaluation (ROV1 and ROV2),
the interaction terms with FIX and INT remain to be positive and significant with compa-
rable magnitude of the coefficients as in the baseline model. In addition, the impact of the
interaction terms on the bond issuance probability is also robust. For the real overvalua-
tion measure computed based on PPP (ROV3), the signs of the estimated coefficients are
also positive after the endogeneity correction, although they are not statistically significant
probably due to the fact that ROV3 itself is a regression residual and is thus harder to be
approximated by instrumental variables. Overall, the relation between exchange rate policy
and the bond issuing and pricing is robust to endogeneity corrections for both exchange
rate regime and real exchange rate overvaluation.

5 Conclusion

This study is the first empirical work on the impact of exchange rate policy on the issuing
and pricing of international bonds. The exchange rate policy is jointly measured by the
exchange rate regime and a measure of exchange rate overvaluation. The main conclusion
is that there is a significant impact of exchange rate policy on LDC foreign borrowing, in
terms of bond issuance decision and the bond spread. Exchange rate policy affects the bond

23
spread in a significant and interlaced way. First, countries with a less flexible exchange rate
regime are less likely to issue bonds and pay higher spreads. Second, when the real exchange
rate is overvalued, countries tend to issue more debt. But depreciation risk associated with
an overvalued real exchange rate has a negative impact on debt sustainability, and thus
increases bond spreads, especially under hard pegs.
To conclude, the choice of an exchange rate policy is not neutral with respect to the
bond issuing and pricing decisions. Attempts to gain credibility in the international market
through the use of a pegged exchange rate have gained popularity. Overvaluation under
hard pegs incites governments to borrow more in the international market; however, foreign
investors internalize the risks associated with the overvaluation, increasing borrowing costs.
Our results emphasize that the choice of a hard peg does not necessarily lead to cheaper
borrowing costs, if there is a severe risk of currency overvaluation.
A couple of research questions still remain. In particular, one would want to construct
a theoretical framework to examine a government’s optimal choice in terms of foreign bor-
rowing and default under different exchange rate regimes in a dynamic stochastic general
equilibrium model. The empirical findings provided in this paper show that it is a priority
to develop new theories that incorporate exchange rate policy and monetary policy into the
analysis of sovereign default and financial crises for developing countries.

24
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Appendix: Definition of Variables
Table A1: Variables, Definitions and Sources
Variable Definitions and Sources
AFRI Dummy variable for African countries
AMOUNT US$ equivalent amount of bond (Source: Bondware)33
CA2GDP Current account balance as % of GDP
(Source: WDI, variable BN.CAB.XOKA.GD.ZS )
DCRISIS Dummy for debt crisis (Source: Reinhart and Rogoff (2008))
DRES Dummy for debt rescheduling (Source: GDF, series DT.TXR.DPPG.CD)
DS2EX Total debt service (% of exports)
(Source: WDI, variable DT.TDS.DECT.EX.ZS)
DT2GNP External debt stocks (% of GNI)
(Source: WDI, variable DT.DOD.DECT.GN.ZS)
GDPGR GDP growth rate (Source: WDI, variable NY.GDP.MKTP.KD.ZG)
GDPPC GDP per capita (current US$) (Source: WDI, variable NY.GDP.PCAP.CD)
HYD Log of Moody’s seasoned Baa corporate bond yield less USRATE
(Source: Federal Reserve Board)
INF Inflation, consumer prices (Source: WDI, variable FP.CPI.TOTL.ZG)
ISSUES Total number of bond issues in a given year (Source: Bondware)
LAT Dummy variable for Latin American countries
RES2GNI Total reserves (% of GNI) (Source: WDI, variables FI.RES.TOTL.DT.ZS
*DT.DOD.DECT.GN.ZS/100)
ROV1 REER Deviation from 10-year average, monthly (Source: IMF)
ROV2 REER 5-year percentage appreciation, monthly (Source: IMF)
ROV3 Exchange rate misalignment measure (Source: PWT)34
SHORTDT Short-term debt (% of total external debt)
(Source: WDI, variable DT.DOD.DSTC.ZS)
SPREAD Launch spreads in basis point, monthly (Source: Bondware)
USRATE The yield on ten-year U.S. treasury bonds at time of issue (log)
(Source: Federal Reserve Board)

33
Unless otherwise specified, the explanatory variables are obtained at an annual frequency and are lagged
for one year to avoid the simultaneity issue.
34
It is constructed by following Dollar (1992) and Aghion et al. (2009). Specifically, we perform the
following pooled OLS regression: log (REERi,t ) = α + βdt + γ log (GDP P Ci,t ) + δLACi + ηAF RIi + i,t ,
where dt is the year dummy. The regression results are consistent with Aghion et al. (2009): γ e = 0.210c ,
e c
δ = 0.077 , γ c
e = 0.068 , and the adjusted R-square is 0.24, where c denotes 1% significance.

29
 Table 1: List of Countries and The Number of Bond Issues

This table lists the names of 42 countries and the number of bond issues in the sample.

Country # Country # Country #

Argentina 289 El Salvador 14 Peru 19
Azerbaijan 2 Grenada 1 Philippines 130
Bolivia 1 Guatemala 8 Poland 20
Brazil 692 India 60 Romania 5
Bulgaria 3 Indonesia 107 Russia 190
Chile 71 Jamaica 20 South Africa 22
China, P. R. 93 Jordan 5 Sri Lanka 4
Colombia 58 Kazakhstan 69 Thailand 78
Congo, Republic of 1 Latvia 1 Turkey 97
Costa Rica 11 Malaysia 54 Ukraine 36
Croatia 4 Mauritius 7 United Arab Emirates 32
Dominican Republic 8 Mexico 336 Uruguay 30
Ecuador 5 Moldova 2 Venezuela 56
Egypt 3 Pakistan 8 Vietnam 1

Table 2: Exchange Rate Regime Classification

Exchange rate regimes are aggregated to three groups: fixed, intermediate, and floating
regimes. We use the exchange rate classification from Reinhart and Rogoff (2002).

Aggregate Class Reinhart and Rogoff (2002) Classification

Fixed (1) No separate legal tender
(FIX) (2) Pre-announced peg or currency board arrangement
Intermediate (3) Pre-announced horizontal band that is less than or equal to ±2%
(INT) (4) De facto peg
(5) Pre-announced crawling peg
(6) Pre-announced crawling band that is less than or equal to ±2%
(7) De factor crawling peg
(8) De facto crawling band that is less than or equal to ±2%
(9) Pre-announced crawling band that is greater than or equal to ±2%
(10) De facto crawling band that is less than or equal to ±5%
(11) Moving band that is less than or equal to ±2%
(i.e., allows for both appreciation and depreciation over time)
Floating (12) Managed floating
(FLOAT) (13) Freely floating

30
 Table 3 Baseline Model with Exchange Rate Regime

This table reports the regression results regarding the role of the exchange rate regime
in affecting launch spreads. The second column shows the result using the pooled OLS
regression. The third and fourth columns show the MLE result using the Heckman’s sample
selection model. t-statistics are shown in parentheses for key variables of exchange rate
regimes (FIX and INT). We calculate t-statistics using robust standard errors.35

OLS Heckit Model

Spread Spread Issuance
FIX 0.392c 0.398c -0.178a
(7.120) (7.600) (-1.921)
INT 0.137c 0.152c -0.120a
(2.976) (3.365) (-1.702)
AMOUNT 0.015b 0.009 0.138c
ISSUES 0.005c 0.005c 0.039c
USRATE -0.218 -0.159 -1.198a
HYD 0.859 0.976 -2.274b
GDPGR -0.009b -0.011b 0.030c
GDPPC -0.094c -0.106c 0.176c
CA2GDP 0.026c 0.024c 0.050c
DT2GNP 0.007c 0.007c -0.007c
DS2EX 0.061 -0.023 1.419c
SHORTDT -0.003 -0.003 0.009c
INF 0.010b 0.008b 0.017
AFRI 0.416c 0.488c -0.901c
LAC 0.341c 0.361c -0.319c
JAN -0.149b
CONSTANT 5.841c 5.936c -0.066
No of bonds 1976 1976
No of obs. 1976 7410
rho -0.145b
lambda -0.082

35
The superscripts a, b, c denote the significance level – a : significant at 10%; b : significant at 5%; c :
significant at 1%. We use them in all the other tables as well.

31
Table 4A: Model with Exchange Rate Regime and Real Overvaluation (ROV1)

This table reports the regression results based on the Heckman’s sample selection model
regarding the role of exchange rate regimes and exchange rate overvaluation in affecting
launch spreads. t-statistics are shown in parentheses for key variables of exchange rate
regimes (ROV1, FIX, INT and their interaction terms). ROV1 is defined as the percentage
deviation of the REER from its ten year average. We calculate t-statistics using robust
standard errors.
Heckit Model (I) Heckit Model (II) Heckit Model (III)
Spread Issuance Spread Issuance Spread Issuance
ROV1 0.010c 0.003b 0.009c 0.004c
(11.126) (2.276) (8.520) (2.693)
ROV1 0.015c 0.021c
×FIX (8.795) (5.689)
ROV1 0.007c 0.002
×INT (5.406) (1.087)
ROV1 0.007c -0.005a
×FLOAT (3.544) (-1.701)
FIX 0.201c -0.193b 0.030 -0.460c
(3.464) (-2.020) (0.419) (-3.860)
INT 0.092b -0.102 0.134c -0.048
(2.122) (-1.412) (2.977) (-0.671)
AMOUNT 0.003 0.171c 0.011 0.161c 0.013 0.174c
ISSUES 0.004c 0.032c 0.003c 0.033c 0.003b 0.030c
USRATE 0.106 -1.121a 0.101 -1.117a 0.184 -1.103a
HYD 1.300b -2.248b 1.313b -2.243b 1.416b -2.230b
GDPGR -0.009a 0.021c -0.011b 0.022c -0.017c 0.016b
GDPPC -0.243c 0.160c -0.256c 0.159c -0.235c 0.187c
CA2GDP 0.030c 0.050c 0.027c 0.051c 0.026c 0.051c
DT2GNP 0.010c -0.007c 0.009c -0.006c 0.009c -0.007c
DS2EX 0.267b 1.379c 0.243b 1.363c 0.186 1.177c
SHORTDT 0.001 0.010c 0.001 0.010c 0.001 0.009c
INF 0.001 0.018 0.003 0.017 0.004 0.014
AFRI 0.639c -0.936c 0.689c -0.959c 0.650c -1.030c
LAC 0.475c -0.399c 0.481c -0.390c 0.455c -0.432c
JAN -0.130a -0.130a -0.138a
CONSTANT 6.325c -0.120 6.384c -0.042 6.088c -0.191
No of bonds 1934 1934 1934
No of obs. 6836 6836 6836
rho -0.179b -0.183b -0.194b
lambda -0.099 -0.101 -0.107

32
Table 4B: Model with Exchange Rate Regime and Real Overvaluation (ROV2)

This table reports the regression results based on the Heckman’s sample selection model
regarding the role of exchange rate regimes and exchange rate overvaluation in affecting
launch spreads. t-statistics are shown in parentheses for key variables of exchange rate
regimes (ROV2, FIX, INT and their interaction terms). ROV2 is defined as the percentage
change in the REER over the last five years. We calculate t-statistics using robust standard
errors.
Heckit Model (I) Heckit Model (II) Heckit Model (III)
Spread Issuance Spread Issuance Spread Issuance
ROV2 0.004c 0.000 0.004c 0.001
(8.170) (0.473) (6.787) (0.794)
ROV2 0.004c 0.003
×FIX (5.347) (1.443)
ROV2 0.004c 0.000
×INT (4.180) (0.154)
ROV2 0.003b -0.002
×FLOAT (2.493) (-0.821)
FIX 0.298c -0.189b 0.296c -0.249b
(5.476) (-2.039) (4.988) (-2.453)
INT 0.145c -0.109 0.150c -0.095
(3.280) (-1.540) (3.212) (-1.323)
AMOUNT 0.000 0.152c 0.012 0.141c 0.013 0.147c
ISSUES 0.004c 0.036c 0.003c 0.037c 0.003b 0.036c
USRATE 0.001 -1.078a 0.040 -1.079a 0.045 -1.111a
HYD 1.245a -2.115b 1.333b -2.120b 1.352b -2.149b
GDPGR -0.007 0.025c -0.010b 0.026c -0.011b 0.024c
GDPPC -0.142c 0.194c -0.179c 0.196c -0.180c 0.201c
CA2GDP 0.030c 0.050c 0.025c 0.051c 0.024c 0.050c
DT2GNP 0.009c -0.007c 0.009c -0.007c 0.009c -0.007c
DS2EX 0.133 1.419c 0.132 1.397c 0.094 1.361c
SHORTDT 0.001 0.008c 0.000 0.008c 0.000 0.008c
INF 0.014c 0.017 0.015c 0.017 0.015c 0.017
AFRI 0.487c -0.903c 0.589c -0.931c 0.582c -0.952c
LAC 0.415c -0.370c 0.432c -0.362c 0.432c -0.374c
JAN -0.146a -0.147a 5.886c -0.148a
CONSTANT 5.758c -0.433 5.870c -0.352 5.886c -0.316
No of bonds 1970 1970 1970
No of obs. 7264 7264 7264
rho -0.164b -0.170b -0.177b
lambda -0.092 -0.094 -0.099

33
Table 4C: Model with Exchange Rate Regime and Real Overvaluation (ROV3)

This table reports the regression results based on the Heckman sample selection model
regarding the role of exchange rate regimes and exchange rate overvaluation in affecting
launch spreads. t-statistics are shown in parentheses for key variables of exchange rate
regimes (ROV3, FIX, INT and their interaction terms). ROV3 is defined as the deviation
from a predicted level of the real exchange rate, which is obtained based on the equilibrium
concept of Purchasing Power Parity and is adjusted for the “Balassa-Samuelson” effect. We
calculate t-statistics using robust standard errors.

Heckit Model (I) Heckit Model (II) Heckit Model (III)

Spread Issuance Spread Issuance Spread Issuance
ROV3 0.222c 0.021 0.097 0.021
(3.864) (0.352) (1.474) (0.331)
ROV3 1.576c 0.685c
×FIX (9.108) (2.736)
ROV3 0.048 -0.058
×INT (0.691) (-0.831)
ROV3 -0.044 0.235
×FLOAT (-0.316) (1.190)
FIX 0.339c -0.033 -0.152b -0.114
(6.621) (-0.360) (-2.044) (-1.134)
INT 0.091b -0.041 0.044 -0.078
(2.030) (-0.628) (1.022) (-1.123)
AMOUNT -0.004 0.125c 0.007 0.123c 0.005 0.115c
ISSUES 0.002c 0.047c 0.002b 0.047c 0.003c 0.047c
USRATE 0.593c -0.218 0.479c -0.206 0.447c -0.221
HYD 2.314c -1.000c 2.255c -1.004c 2.278c -1.014c
GDPGR -0.014c 0.034c -0.018c 0.035c -0.023c 0.033c
CA2GDP 0.025c 0.042c 0.020c 0.042c 0.024c 0.042c
DT2GNP 0.007c -0.006c 0.006c -0.006c 0.006c -0.006c
DS2EX 0.193b 1.334c 0.199b 1.319c 0.127 1.201c
SHORTDT -0.002 0.008c -0.004a 0.008c -0.004a 0.008c
INF 0.010c 0.001 0.014c 0.000 0.014c -0.000
JAN -0.162b -0.159b -0.156b
CONSTANT 3.847c -0.739a 3.969c -0.727a 4.049c -0.647a
No of bonds 7410 7410 7410
No of obs. 1976 1976 1976
rho -0.224c -0.186c -0.134b
lambda -0.133 -0.109 -0.077

34
 Table 5A: Exchange Rate Regime: Endogeneity Correction

This table reports the regression results regarding the role of the exchange rate regime
in affecting launch spreads. Column (I) shows the result using the pooled OLS regression.
Column (II) shows the MLE result based on the Heckman’s sample selection model. Col-
umn (III) shows the MLE result from using instrumental variables (IV) to deal with the
potential endogeneity problem associated with exchange rate regime. t-statistics are shown
in parentheses for key variables of exchange rate regimes (FIX, INT, FIXALL). FIXALL
is a dummy variable for countries with de facto pegs throughout our sample period. We
also include additional control variables of DRES, DCRISIS and RES2GNI. We calculate
t-statistics using robust standard errors.

OLS (I) Heckit Model (II) Heckit Model (III)

Spread Spread Issuance Spread Issuance
FIX 0.350c 0.353c -0.115 0.496c -0.233
(6.527) (6.866) (-1.146) (7.124) (-1.546)
INT 0.235c 0.241c -0.069 0.347c 0.313b
(5.096) (5.553) (-0.934) (4.573) (2.269)
FIXALL 0.729b 0.761c -0.349
(2.567) (4.324) (-1.529)
DRES 0.168c 0.168c -0.027 0.182c -0.030
DCRISIS -0.012 0.001 -0.278 0.056 -0.061
RES2GNI -0.030c -0.030c -0.011c -0.030c -0.014c
AMOUNT 0.009 0.006 0.127c 0.014 0.150c
ISSUES 0.001 0.001 0.038c -0.000 0.036c
USRATE -0.266 -0.232 -1.148a -0.240 -1.198a
HYD 0.576 0.646 -2.272b 0.530 -2.378b
GDPGR -0.007a -0.009a 0.029c -0.010b 0.025c
GDPPC 0.007 -0.003 0.288c 0.002 0.377c
INF 0.003 0.002 0.013 0.005 0.014
CA2GDP 0.040c 0.038c 0.052c 0.035c 0.054c
DT2GNP 0.009c 0.009c -0.005c 0.008c -0.005c
DS2EX 0.021 -0.024 1.270c 0.018 1.395c
SHORTDT 0.001 0.001 0.006c 0.001 0.006c
AFRI 0.159 0.204 -0.998c 0.140 -0.987c
LAC 0.168c 0.184 c -0.447c 0.161c -0.489c
JAN -0.142a -0.142a
CONSTANT 5.600c 5.672c -0.744 5.601c -1.557
No of bonds 1972 1972
No of obs. 1972 7262 7262
rho —0.087 -0.081
lambda -0.047 -0.043

35
Table 5B: Exchange Rate Regime and Overvaluation: Endogeneity Correction

This table reports the regression results from using instrumental variables (IV) to deal
with the potential endogeneity problem associated with both exchange rate regime and
real overvaluation. Heckit Models (I-III) are for ROV1-ROV3, respectively. t-statistics
are shown in parentheses for key variables of exchange rate regime, overvaluation and their
interactions. We also include additional control variables of DRES, DCRISIS and RES2GNI.
We calculate t-statistics using robust standard errors.

Heckit Model (I) Heckit Model (II) Heckit Model (III)

Spread Issuance Spread Issuance Spread Issuance
ROV 0.058c 0.069c 0.027c 0.004 0.468 -1.233a
×FIX (6.470) (4.386) (5.224) (0.436) (1.530) (-1.958)
ROV 0.036c 0.022c 0.014c -0.013b 0.177 -0.322b
×INT (6.229) (2.824) (3.375) (-2.046) (1.551) (-2.110)
ROV 0.023c 0.012 0.008a -0.013a 0.263 -0.684a
×FLOAT (4.025) (1.286) (1.753) (-1.857) (1.066) (-1.646)
FIX -0.240 -1.148c -0.049 -0.378 0.443c -0.098
(-1.602) (-4.417) (-0.400) (-1.593) (5.079) (-0.635)
INT 0.308c 0.338b 0.373c 0.459c 0.272c 0.095
(3.560) (2.258) (4.284) (2.973) (3.510) (0.745)
DRES -0.051 -0.247c 0.023 0.098 0.180c 0.062
DCRISIS 0.347c 0.113 0.121 -0.051 -0.085 -0.457b
AMOUNT -0.017c -0.006 -0.022c -0.020c -0.026 c -0.002
ISSUES 0.049c 0.184c 0.041c 0.157c 0.016a 0.151c
USRATE -0.006c 0.027c -0.004b 0.033c -0.002 0.046c
HYD 0.385 -0.718 0.258 -1.530b 0.146 -0.134
GDPGR 1.610c -1.520 1.231b -2.893c 1.875 c -0.980c
GDPPC -0.016c 0.017c -0.007 0.017b -0.017 c 0.031c
INF -0.418c 0.122 -0.210 c 0.567c
CA2GDP -0.001 0.017 0.035c 0.011 0.008c 0.004
DT2GNP 0.026c 0.050c 0.026c 0.054c 0.037c 0.039c
DS2EX 0.009c -0.003b 0.010c -0.006c 0.007c -0.006c
SHORTDT 0.744c 1.837c 0.441 c 1.090c 0.216b 1.612c
RES2GNI 0.007c 0.008c 0.005 b 0.004b 0.000 0.010c
AFRI 0.329b -0.790c 0.305a -1.153c
LAC 0.328c -0.359c 0.285 c -0.624c
JAN -0.140a -0.143a -0.154b
CONSTANT 7.026c -0.944 5.783c -2.081 4.642c -1.150c
No of bonds 1972 1972 1972
No of obs. 7262 7262 7262
rho 0.003 -0.026 -0.056
lambda 0.528 0.531 0.549

36
 Table 5C: Instruments for Exchange Rate Regime and Overvaluation

The second and the third columns in this table report the multinomial logit regression
results, which are used to generate the fitted values of exchange rate regimes FIX and INT as
their instruments. The dependent variable is the categorical exchange rate class (FIX, INT,
or FLOAT). The last three columns report the OLS regression results, which are used to
generate the fitted values of the three exchange rate overvaluation measures (ROV1, ROV2,
ROV3), respectively. The explanatory variables include all the exogenous variables used in
Tables 5A-5B, as well as seven additional variables WORKPOP, OILEX, AREA, ISLAND,
REGEXCH, RESBASE, and SIZE as proposed in Levy-Yeyati and Sturzenegger (2003),
Prasad, Rajan, and Subrahmanian (2006) and Eichengreen (2008). WORKPOP, obtained
from WDI (variable SP.POP.1564.TO.ZS), is the proportion of total population whose ages
are between 15 and 64. OILEX is a dummy for oil exporting countries. AREA, obtained
from WDI (variable AG.LNK.TOTL.k2) is land area in sq. km. ISLAND is a dummy for
countries with no mainland territory. RESBASE, obtained from IMF (line 11/line 14), is the
initial ratio of “International Reserves” to “Monetary Base”. RESEXCH is the (monthly)
average RR exchange rate regime of the region where the regions are defined as those under
the same IMF department. SIZE, obtained from WDI (variable NY.GDP.MKTP.CD), is
a country’s GDP in dollars over U.S. GDP. For simplicity, only the regression coefficients
and the corresponding t-statistics for the seven additional variables are reported below.
t-statistics are shown in parentheses, which are calculated using robust standard errors.

Multinomial Logit OLS

FIX INT ROV1 ROV2 ROV3
WORKPOP -0.181c 0.019 -0.428c 0.060 -0.022c
(-5.936) (0.864) (-6.777) (0.605) (-26.111)
OILEX 6.814c 1.454c 6.708c 8.824c 0.032c
(20.722) (7.160) (13.056) (10.822) (4.173)
AREA -0.827c 0.344c -0.214b -0.521c -0.017c
(-6.346) (10.792) (-2.110) (-3.584) (-12.087)
ISLAND -0.357 -1.775c 1.186b -2.272c -0.263c
(-1.479) (-11.181) (2.215) (-2.619) (-30.524)
REGEXCH 0.900c 1.246c -2.945c -1.758c -0.146c
(4.633) (8.917) (-7.530) (-2.791) (-25.899)
RESBASE -1.918c -0.206c -1.554c -2.829c 0.012c
(-16.116) (-3.119) (-6.875) (-7.809) (3.471)
SIZE -25.353c -4.900c -0.758 -4.570c 0.078c
(-16.024) (-17.506) (-0.727) (-2.727) (4.695)
No of obs. 7572 7078 7453 7572
pseudo R2 0.589 0.400 0.286 0.503

37