An empirical inquiry into the role of sectoral diversification in exchange rate regime choice

Whether sectoral diversification affects the exchange rate regime choice and the mechanisms through which this effect might work are largely unknown. This study identifies two mechanisms through which sectoral diversification and exchange rate regime choice may be related, namely the external shock absorption and rent-seeking mechanisms. A direct effect of diversification on regime choice is also hypothesized. Using a panel dataset covering 91 countries over the period 1985-2006, the paper runs a 'horse race' among these potential channels. The results show that diversification is associated with flexible regimes in countries experiencing greater external shocks. Additionally, countries characterized by higher levels of corruption and lower levels of diversification opt for fixed regimes, suggesting that a fixed regime may shield the powerful elites from international competition. There is also weak evidence of the direct effect of diversification in adopting flexible regimes.