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Working Paper Summaries (WP/93/55 - WP/93/95)
Article

Summary of WP/93/83: “Expected Devaluation and Economic Fundamentals”

Author(s):
International Monetary Fund
Published Date:
January 1994
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The two episodes of exchange rate collapse within the exchange rate mechanism (ERM) of the European Monetary System in September 1992 and August 1993 have kindled tremendous interest in understanding the causes of such forced parity changes. After a period of five years with fixed central parities, pressure built up during the summer of 1992 against the pound and lira which led to the suspension of both currencies from the ERM. At the beginning of August 1993, a communiqué was issued announcing the widening of the obligatory marginal intervention thresholds of the remaining participants in the ERM to ±15 percent around each central parity.

This paper addresses the question of whether--and if so, how--these episodes of exchange market pressure are related to economic fundamentals by considering the examples of France and Italy. It demonstrates that the interest rate differential corrected for expected depreciation within the band is a reasonable estimate of expected devaluation for France, Italy, and the United Kingdom. The estimate of expected devaluation for the French franc, unlike the estimate for the Italian lira, can partly be explained by variables which reflect external and internal imbalances. In the analysis, the dominant explanatory variable is the position of each currency in its target band, and this variable is only weakly related to standard macroeconomic fundamentals. When the band position variable is excluded from the analysis, official holdings of foreign exchange reserves become a significant determinant. However, the effect of the standard macroeconomic fundamentals is weak because no variable provides significant explanatory power for France and Italy over the whole period, and only the unemployment rate provides significant explanatory power for Italy for the subperiod 1987-92.

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