Financial liberalization and the stability of currency pegs

This paper analyzes how the strategies of domestic firms borrowing abroad complicate the interaction between central banks and foreign exchange short sellers. If we define financial liberalization as the degree of freedom given to domestic firms to borrow abroad, we find that, in the early stages of financial liberalization, foreign borrowing does not affect the stability of the currency peg, but, in the advanced stages of financial liberalization, foreign borrowing destabilizes currency pegs. When this happens, we show that policies to curb currency short sellers have no effect. The paper thus formalizes the critical juncture where financial liberalization and currency pegs become incompatible policy goals.