Beware: without independent central banks, international reserves are at the mercy of governments in election years

Macroeconomics - Economic growth - Monetary Policy
Politics and Economy

Many central banks in Latin America are subject to the political influence of the government. This is keenest at election time, when there are episodes of postponement of nominal exchange rate adjustments, something which in turn translates into depreciations of the real exchange rate.[1]

If central banks tend to postpone exchange rate adjustments until after elections, they have to be willing to lose reserves before elections in order to stabilize the exchange rate. Following this conjecture, in a recent paper we study electoral cycles in international reserves in twenty-two countries from Latin America over the 1980–2005 period. A group of twenty-four countries from the OECD is taken as a comparison group.

Figure 1 shows the behavior of the growth rate of real foreign exchange reserves in a five-year window centered in the election year (year 0). There is evidence of a strong electoral cycle in Latin America. The OECD, in contrast, shows a flat line.

Figure 1. Annual rate of variation of international reserves around election years (in %)

International reserves around election years

Dreher and Vaubel (2009) already find that, in developing countries, reserves drop significantly before elections. Since monetary policy is typically delegated to a central bank, a crucial issue is its independence. Keefer and Stasavage (2003) find that if the executive power faces effective political veto players, the replacement of central bank governors is less likely, which indicates higher independence. Inflation is lower, so there is also higher credibility.

Hence, we analyze if an explanation for why reserves show no electoral pattern in OECD countries has to do with institutional constraints on executive discretion. We focus on legislative checks and balances in countries with strong rule of law, drawing on the Henisz (2002) political constraints index and combining it with the ICRG law and order index. There is a much weaker rule of law in Latin America, which can create particularly strong credibility problems in election years.

Once we control for effective checks and balances on executive discretion, we find that reserves fall in election years in both regions if there are no effective checks and balances. However, effective checks and balances are much larger in OECD countries, which explains why there is an electoral cycle only in Latin America.

How to interpret these electoral cycles? For Drazen (2001), monetary policy has a passive role of accommodating active fiscal policy, which he considers is the main impulse behind electoral cycles. There are indeed strong electoral cycles in fiscal policy in Latin America. A non-independent central bank can lead to exacerbate these cycles (Haga 2012).

However, something more than simple monetary accommodation might be at play in Latin America. On the one hand, while there are electoral cycles in fiscal policy in both regions, only Latin American countries show a compensating fiscal adjustment after elections (Streb, Lema, and Garofalo 2012). On the other hand, the exchange rate adjustments after elections in Latin America may be playing a role in the post-electoral fiscal adjustments. These features do not point to passive monetary policy, but rather to the fiscal dominance of monetary policy.

The process of losses of reserves before elections and depreciations after elections can be linked to the perverse monetarist arithmetic of Sargent and Wallace (1981) and the episodes of temporary stabilizations in Calvo and Végh (1999): when there is asymmetric information on policy decisions, the government can temporarily lower the inflation tax before elections by resorting to debt in order to appear more competent. The downside is that this will imply more inflation after elections. More generally, the pre-electoral manipulation of fiscal policy can be interpreted as part of a cycle by which fiscal expansions before elections are corrected through an inflation tax after elections. Devaluations not only provide higher government revenues, they can also be used to wipe out, in real terms, the nominal increase of government expenditure before elections.

In conclusion, lower effective checks and balances on executive discretion can explain why international reserves fall significantly before elections in Latin America, but not in the OECD. More speculatively, monetary policy in Latin America not only has had to accommodate stronger electoral cycles in fiscal policy, but also to subordinate itself to the fiscal needs of the government.

1. See Stein and Streb (2004) on nominal devaluations, and Cermeño, Grier, and Grier (2010) on real depreciations.


Calvo, Guillermo, and Carlos Végh (1999). Inflation stabilization and BOP crises in developing countries. In: J. Taylor and M. Woodford, eds., Handbook of macroeconomics, Amsterdam: North Holland.

Cermeño, Rodolfo, Robin Grier, and Kevin Grier (2010). Elections, exchange rates and reform in Latin America. Journal of Development Economics 92: 166–174.

Drazen, Allan (2001). Twenty–five years of political business cycles. NBER Macroeconomics Annual 2000, Cambridge, MA: NBER.

Dreher, Axel, and Roland Vaubel (2009). Foreign exchange intervention and the political business cycle: A panel data analysis. Journal of International Money and Finance 28: 755–775

Haga, Mercedes (2012). On central bank independence and political cycles. Manuscript, Universidad Diego Portales.

Henisz, Witold J. (2002). The institutional environment for infrastructure investment. Industrial and Corporate Change 11: 355–89.

Keefer, Philip, and David Stasavage (2003). The limits of delegation: Veto players, central bank independence, and the credibility of monetary policy. American Political Science Review 97: 407-423.

Sargent, Thomas, and Neil Wallace (1981). Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review 5, 1–17.

Stein, Ernesto H., and Jorge M. Streb (2004). Elections and the timing of devaluations. Journal of International Economics 63: 119–145.

Streb, Jorge M., Daniel Lema, and Pablo Garofalo (2012). Temporal aggregation in political budget cycles. Economía, Journal of the Latin American and Caribbean Economic Association 13: 39–78.

Streb, Jorge M., Daniel Lema, and Pablo Garofalo (2013). Electoral cycles in international reserves: Evidence from Latin America and the OECD. Revista de Economia del Banco Central del Uruguay 20 (2): 27–60.

Share this