Soft power and exchange rate volatility

• DOI: http://doi.org/10.1111/infi.12117
• Author: Richard D. F. Harris,Serhan Cevik,Fatih Yilmaz
• Date: 01 December 2017
• Published date: 01 December 2017

DOI: 10.1111/infi.12117

ORIGINAL MANUSCRIPT

Soft power and exchange rate volatility

Serhan Cevik

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RichardD.F.Harris

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Fatih Yilmaz

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1

International Monetary Fund,

Washington, District of Columbia

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University of Exeter, Exeter, UK

3

Eurizon SLJ Capital Limited, London,

UK

Correspondence

Serhan Cevik, International Monetary

Fund, 700 19th Street, NW, Washington,

DC 20431.

Email: scevik@imf.org

Abstract

Standard models—based exclusively on macro-financial

variables—have made little progress in explaining the

behaviour of exchange rates. In this paper, we introduce a

neglected set of ‘soft power’factors capturing a country's

demographic, institutional, political, and social underpinnings

to shed some light on the ‘missing’determinants of exchange

rate volatility over time and across countries. Based on a

balanced panel dataset comprising 115 countries during the

period 1996–2015, the empirical results are generally robust

across different estimation methodologies and show a high

degree of persistence in exchange rate volatility. After

controlling for standard macroeconomic factors, we find that

the ‘soft power’variables—such as an index of voice and

accountability, life expectancy, educational attainments,

fragility of the banking sector, financial openness, and the

share of agriculture relative to services—have a statistically

significant influence on the level of exchange rate volatility

across countries. In other words, countries with greater ‘soft

power’(i.e. better institutional quality) tend to experience a

lower degree of exchange rate volatility.

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INTRODUCTION

Since the breakdown of the Bretton Woods system, major shifts in the global economy and financial

markets have exacerbated the magnitude of exchange rate fluctuations. While Friedman (1953)

famously argued that exchange rate volatility is a manifestation of macroeconomic volatility, empirical

The International Monetary Fund retains copyright and all other rights in the manuscript of this article as submitted for

publication.

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studies have uncovered a range of anomalies and puzzles that contradict the theoretical models of

exchange rates. Meese and Rogoff (1983), for example, showed that there is no stable relationship

between exchange rate fluctuations and fundamental factors, conflicting with the theoretical models

predicting that exchange rate volatility can only increase when the variability of the underlying

fundamentals increases. Exchange rate volatility is still of great interest to academics, policymakers,

and market practitioners because of the potential linkages between the behaviour of exchange rates and

other economic and financial variables.

The general consensusin the literature is that exchange rate volatility reflectsa variety of global and

country-specific factors, such as income growth, inflation, fiscaland current account balances, foreign

exchange reserves, financialand trade openness, and the size and type of capital flows. It has also been

shown thatstructural characteristics ofthe foreign exchange market such as the exchangerate regime and

technical featuressuch as order flows influence the extent of exchangerate volatility. Notwithstandinga

cascade of follow-up papers, however, the findings of Meese and Rogoff (1983) remain unchallenged,

with little progress in explaining—and predicting—exchange rate fluctuations with macroeconomic

fundamentals.If exchange rates fluctuate beyondwhat is necessary to absorb real economicshocks, they

becomean autonomous source of shocks and instability.A significant share of exchange rate fluctuations

is indeed shown to be explained by shocks originating in the foreign exchange market itself, due to

movements in the exchange rate risk premium (Artis & Ehrmann, 2006; Farrant & Peersman, 2006).

The purpose of this paper is therefore to empirically shed some light on the ‘missing’cross-country

determinants of exchange rate volatility. Using a balanced panel comprising 115 countries from 1996

to 2015, we investigate the importance of ‘soft power’variables that encapsulate a country's

demographic, institutional, political, and social underpinnings that are generally ignored in the

literature.

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In addition, we include a variety of control variables, drawn from the literature on exchange

rate modelling, and which are expected to capture the conventional macro-financial determinants of

exchange rate volatility. With regards to the ‘soft power’characteristics of individual countries, rather

than relying on an arbitrary choice of a small set of variables, we take an ‘agnostic’view and initially

consider a wide range of demographic, institutional, political, and social indicators. However, since

there is inevitably a high degree of collinearity among the explanatory variables, we utilize a variable

reduction technique that systematically eliminates those variables in the original set that are best

explained by the remaining variables.

While there is no theoretical model linking ‘soft power’toexchange rate volatility, we consider the

institutions-growth nexus—a widespread consensus in the literature—as a useful illustration of the

linkages we have in mind betweena country's ‘soft power’characteristics—underpinning its quality of

institutions—and exchange rate fluctuations. Accordingly, we expect ‘soft power’factors to have a

noticeable effecton exchange rate volatility—directly and indirectly—byenhancing complementarities

between different kind of institutions, fostering better policy choices and shaping the pattern and

evolution of macroeconomic fundamentals andrisk premia. We present cross-country evidencethat the

volatilityof exchangerates is significantly affected by ‘soft power’variables—suchas an index of voice

and accountability, life expectancy, educational attainments, fragility of the banking sector, financial

openness, and the shareof agriculturerelative to services. Our empirical analysis indicatesthat countries

with greater ‘soft power’experience less exchange rate volatility.The results are robust to a number of

important sensitivity checks, including different estimation approaches, sub-sample analysis, and

controlling for a host of conventional macroeconomic factors investigated in previous studies.

The remainder of this paper is organized as follows. Section 2 provides a brief overview of the

literature. Section 3 explains how we estimate exchange rate volatility. Sections 4 and 5 describe our

empirical methodology and data sources, respectively. The econometric results are presented in section

6, while we offer concluding remarks in section 7.

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