How Can Fiscal Policy Help Avert Currency Crises?

Considerable attention has been directed at regulating the domestic financial system, tightening the monetary stance, imposing various forms of capital controls, or simply relaxing the exchange rate rule, as a possible means to prevent balance-of-payments crises. Although often regarded as a root cause of external disequilibria, fiscal policy has received mixed treatment as an instrument for arresting an impending crisis. The fiscal solution is usually approached from two different angles. From an orthodox perspective, the misalignment in fundamentals calls for a tough front-loaded fiscal adjustment. The alternative approach, when considering the magnitude of the necessary adjustment and the likely sacrifice in terms of the ensuing output loss, is to delay-either tacitly or openly-the fiscal correction and to rely on short-term financial measures, including an aggressive interest rate policy, until the turbulence in capital markets subsides. As a departure from these contrasting views, this paper explores the effective use of fiscal tools, at the least output cost, in an open emerging-market economy that maintains a pegged exchange rate arrangement, with the purpose of reducing or eliminating its vulnerability to currency crises.