Since the realignment of currencies in the exchange rate mechanism of the European Monetary System (EMS) in January 1987, the differential between French and German interest rates has narrowed considerably. Nevertheless, the persistence of a significant differential across the maturity spectrum suggests that market participants anticipate a realignment of central parities in the EMS before exchange rates are irrevocably fixed in the final stage of European economic and monetary union.
This paper explores the determinants of expected rates of realignment of the French franc/deutsche mark exchange rate. It does so by first estimating expected parity changes and then relating these to economic variables that are believed to influence market participants’ realignment expectations. Time-varying expected rates of realignment are estimated in two ways: one, by adjusting short-term Euromarket interest rate differentials for the expected rate of change of the FF/DM exchange rate within the EMS fluctuation band and, two, by using the differential in the yield on long-term government bonds.
The behavior of the exchange rate within the band is found to be consistent with mean reversion, and the expected change is nontrivial. Thus, by filtering out the expected mean reversion within the band from short-term interest rate differentials, more precise measures of expected changes in the central parity are obtained than those given simply by interest differentials. This adjustment is important because the “credibility bounds” on short-term interest rates are rather large. Realignment expectations are found to be related to the evolution of such fundamental economic variables as inflation differentials, competitiveness, unemployment, government financing requirements, foreign reserves, and, for shorter horizons, the position of the franc in the fluctuation band. France’s favorable economic performance, especially on inflation, the external position, and the fiscal situation, has allowed the implicit expected rate of devaluation to decrease considerably. The analysis in this paper suggests that interest differentials could be narrowed further by an improved labor market performance and, in the case of short-term rates, by a strengthened position of the franc in the fluctuation band.