THIS PAPER ADDRESSES the question of the credibility of Belgium’s exchange rate policy within the European Monetary System (EMS) over a period ranging from the early 1980s almost until the widening of the EMS fluctuation bands in August 1993. During this period, the general trends of the Belgian franc (BF) exchange rate have varied significantly. Over the first half of the period, devaluations vis–à–vis the deutsche mark (DM), either unilateral (as in February 1982) or as part of general EMS realignments, were frequent. Since January 1987, the BF/DM central parity has remained unchanged.

Belgium has been a member of the exchange rate mechanism (ERM) of the EMS since its inception in 1979, with the BF placed in the narrow ± 2.25 percent fluctuation band. Since May 1990, Belgium’s exchange rate policy stance has hardened further, as the monetary authorities announced that the BF would closely track the strongest EMS currency (“franc fort” policy). Since then, and until the widening of the EMS bands from 2.25 percent. to 15 percent in August 1993, BF fluctuations vis–à–vis the DM have been negligible, generally limited to a ± 0.5 percent range (Figure 1).

Given Belgium’s status as a small, open economy, exchange rate policy constitutes an important element of its anti–inflation strategy. Economies such as Belgium are often viewed as suffering from a credibility problem of the type analyzed by Barro and Gordon (1983). In particular, it can be argued that, if an independent monetary policy is pursued, it is difficult to adhere to a time–consistent policy rule. Under these conditions, the rational expectations equilibrium involves a rate of inflation that is higher than the social optimum. Giavazzi and Pagano (1988) argue that such countries can overcome this problem by giving up monetary independence and pegging their currencies to a currency such as the DM, effectively “borrowing” the Bundesbank’s anti–inflation reputation. The argument assumes that the costs of reneging on such a policy are prohibitively high.

Interest rate differentials are an indicator traditionally employed to assess exchange rate credibility. Figure 2 depicts the trends in the long– and short–term Belgian–German interest rate differentials during 1982–92. The figure provides strong prima facie evidence that Belgium has made progress in strengthening the credibility of its exchange rate policy over this period. The long–term differential declined from about 5 percent in 1982 to about 0.7 percent in 1992, whereas the short– term differential, which stood at almost 5 percent in 1982, practically disappeared.

Suggestive as the trends in Figure 2 may be, they fail to provide a conclusive test of exchange rate credibility. In general, the use of interest rate differentials as a credibility indicator in the context of a target zone setting suffers from two limitations: on the one hand, it fails to consider the currency’s position within its fluctuation band; on the other, it does not take into account that the critical level of the interest rate differential at which credibility is rejected varies with the length of the time horizon over which the credibility test is being conducted. These factors turn out to be important components of an adequate exchange rate credibility test.

Figure 1. Recent Evolution of Exchange Rates

Source: IMF, *International Financial Statistics*.

Figure 2. Interest Rate Differentials Versus Germany

Source: IMF, *International Financial Statistics*.

## I. Interest Rate Corridors

An attractive way to overcome the above problems is the “interest rate corridor” approach.^{1} The underlying rationale is straightforward. Consider an *N*–month security denominated in DM. The annualized ex post BF rate of return

where *e* is the BF/DM spot exchange rate.

A credible exchange rate zone would imply that the BF exchange rate is expected to fluctuate within a ± 2.25 percent band:

Two points regarding the above interest rate corridors are immediately apparent. First, for a given German interest rate, a rise in *e* (that is, a BF weakening) shifts the corridor down, since, assuming exchange rate credibility, the weaker the domestic currency, the higher is its potential appreciation and the lower its potential depreciation. Second, the shorter the time horizon, the greater is the width of the corridor, since the potential appreciation or depreciation per unit of time increases.

In using interest rate corridors to assess exchange rate credibility, a fundamental asymmetry of the test should be stressed. Whereas a domestic interest rate above the corridor leads to a rejection of the credibility hypothesis, a domestic rate inside the corridor does not necessarily imply credibility: although the hypothesis cannot be rejected, the hypothesis of an expected devaluation (upward shift in the corridor), such that the domestic interest rate would remain inside the new corridor, also cannot be rejected.

Figure 3 depicts Belgian interest rate corridors for a five–year horizon (based on the government bond yield) and for a three–month horizon (based on the money market rate). It is evident that short–run credibility cannot be rejected, even assuming a very narrow implicit fluctuation band of ± 0.5 percent around the DM following the adoption of the “franc fort” policy. At the same time, it is clear that credibility did not come overnight: there are periods before 1986 for which even short–run credibility is rejected.

Figure 3. Interest Rate Corridors

On the other hand, the hypothesis of long–run credibility is rejected for the entire period, even though the Belgian long–term rate has been approaching the upper bound of its interest rate corridor over time. Thus, in line with Koen’s (1991) conclusions, simple interest rate corridor analysis indicates that the Belgian hard currency policy is not yet credible for the long run, possibly reflecting questions regarding the credibility of overall economic management and the sustainability of the convergence of Belgium’s economic fundamentals toward those of Germany.

A major problem with simple interest rate corridor analysis is that it relies on the strong assumption of uncovered interest rate parity: it assumes, in other words, that interest rate differentials reflect exclusively the expectation of exchange rate changes. To address this problem, the determinants of interest rate differentials will have to be examined in more detail. This analysis will lead to a redefinition of the interest rate corridors appropriate for testing long–run exchange rate credibility.

## II. Determinants of Interest Rate Differentials

This section discusses the formulation of a reduced–form equation that attempts to describe the Belgian–German long–term interest rate differential (RB). The equation will be specified to enable a decomposition of the interest rate differential into an expected exchange rate change and a credit risk component. The latter, in turn, will be assumed to depend on Belgium’s fiscal position relative to that of Germany.

It may be argued that, for a Western European country such as Belgium, sovereign credit risk can be expected to be minimal, even with large fiscal imbalances. In that case, the interest rate corridors of the previous section would provide an adequate credibility test. In my view, this argument is questionable. Even if outright default could be ruled out,^{2} weaker forms of credit risk may still be present. In particular, some types of debt rescheduling, mainly with regard to domestic institutional investors, are not unusual for countries of the European Union (EU). In addition, and perhaps even more relevant, individual countries retain taxation powers, and it is thus reasonable to assume that the market may be discounting the possibility of higher future withholding taxes in response to major fiscal imbalances. These factors would also result in interest rate differentials quite independent of expected future exchange rate movements.

The specification assumes that expected changes in the BF/DM parity are driven by the expected Belgian–German inflation differential (INFLPR). In addition, expected parity changes are also assumed to be influenced by market perceptions of the extent to which the monetary authorities may desire to offset past losses in competitiveness, captured by the difference in the annualized rate of change of the real effective exchange rate between Belgium and Germany (COMP).^{3} A time trend (TIME) is included to account for, among other things, autonomous changes in credibility over time. Finally, to capture the mechanics of the ERM, the following are included as relevant explanatory variables: a (0,1) dummy variable of general exchange rate realignments, not necessarily involving the BF (REAL), and a devaluation variable (DEV) capturing the percentage point changes in the BF/DM central rate, whether as part of a general or a unilateral realignment. The hypothesis to be tested is whether REAL or DEV had any impact on interest rate differentials over the contemporaneous and two succeeding quarters. In addition, an exchange rate regime term (REG) is included, taking the value 2.25 percent up to the second quarter of 1990 and 0.5 percent thereafter, to capture the impact of the “franc fort” policy.

The REAL and DEV terms warrant further discussion. The rationale for including REAL is that, if a general realignment raises questions about the ERM itself, flows might be expected out of the perceived “weak” currencies toward the perceived “strong” currencies of the system. Inclusion of the DEV term enables distinction between two conflicting hypotheses: on the one hand, if the new central rate is perceived by the markets to be more sustainable, support for the new parity may be achieved at a lower interest rate, thus implying a negative coefficient. On the other hand, to the extent that a devaluation reveals information about the monetary authorities’ reaction function and, in particular, if the markets view the devaluation as an indication that the authorities may again resort to this measure in the future in response to adverse trends in competitiveness or the real economy, a larger interest rate differential may be required to hold domestic–currency–denominated assets, implying a positive DEV coefficient.

The fiscal position is described by the debt/GDP ratio differential (DEBT) and the primary surplus/GDP ratio differential between Belgium and Germany (DEFPR). If inflationary expectations are adequately specified, the fiscal variables may be expected to capture the credit risk component of the interest rate differential. The equation to be estimated, therefore, is

where E stands for an error term. The cross term COMP * TIME was included to capture possible linear variation over time of the perceived willingness to accommodate past losses in competitiveness by an exchange rate adjustment.

With regard to the error term, while it is assumed that it is zero mean, there are strong reasons why it may *not* be independently distributed. First, it is implausible to suppose that a new exchange rate system like the EMS in its early stages should be widely known and credible from the moment of its inception. In this respect, models of Bayesian learning about realignment probabilities like Driffill and Miller (1993) would predict serial correlation in the error term of the above equation. Second, it would be reasonable to postulate that learning about the policy preferences of the monetary authorities can be a nontrivial exercise, particularly as parameter estimates derived under a pre–EMS regime would be sensitive to the Lucas (1976) critique. Under these conditions, the authorities may have to resort to signaling in order to reveal crucial aspects of their objective function. Signaling models in the spirit of Vickers (1986) would again predict serial correlation of the error term.

## III. Exchange Rate Risk Versus Credit Risk

To proceed with the estimation of the equation of the previous section, inflationary expectations need to be modeled. The simplest formulation would be to assume that the current inflation differential (INFL) is an adequate proxy for INFLPR. However, the estimation results of the above equation under this assumption appear to contradict this hypothesis (*t*–statistics in parentheses):

The INFL coefficient turns out to be statistically insignificant, suggesting that treating INFL as a proxy for INFLPR results in misspecification.^{4} As a consequence, the estimated coefficients of DEBT and DEFPR would be biased upward as, in addition to capturing the credit risk component of the interest rate differential, they may also reflect the perceived threat of debt monetization. Hence, the above formulation does not appear to offer a solid basis for the decomposition of the differential into an exchange rate risk and a credit risk component.

In the face of this difficulty, expected inflation needs to be estimated. It is assumed that economic agents, in forming expectations of future inflation, take into account the past history of inflation, fiscal variables, and money supply growth (MON). In particular, in making an “optimal” prediction, they are assumed to make use of a “best–fit” equation linking present inflation to a distributed lag of the above variables.

This methodology may be vulnerable to the “peso problem” analyzed by Krasker (1980). This problem arises when large parity changes are expected to occur infrequently, that is, they carry a low probability per unit of time. Under these conditions, the probability that sample averages match “true” expectations is low, even in medium–sized samples. This situation is likely to be particularly relevant in a setting in which the monetary authority is perceived to be pursuing a mixture of fixed exchange rate and discretionary strategy of an “escape clause” type, studied by Flood and Isard (1989) and Cukierman (1990)—an attractive formalization of a system of fixed but adjustable exchange rates. Under this strategy, the fixed exchange rate is expected to be maintained if shocks fall within a certain range, and to be abandoned if they fall outside that range.^{5}

Presented below are the estimation results of such an equation, dropping all variables whose coefficients were statistically insignificant, and using broad money M_{2} as the relevant monetary aggregate.

To estimate the equation of the previous section, the predicted inflation differential from the above regression is included as a proxy for INFLPR. In the absence of credit risk, the fiscal variables, apart from their impact on expected inflation, should have no additional explanatory power. On the other hand, if credit risk were nonnegligible, the coefficient of the fiscal variables, although lower than the corresponding estimates of the equation using INFL as proxy for INFLPR, should still turn out to be statistically significant. The estimation results are

Dropping the statistically insignificant variables, the estimation results are

The main results can be summarized as follows:

(1) The constant term turned out to be statistically insignificant and was dropped from the regression. There is no evidence of a “structural” long–term interest rate differential between Belgium and Germany emanating from imperfections in capital flows, imperfect asset substitutability owing, for example, to different liquidity characteristics, or other factors.

(2) Expected inflation turns out to be statistically significant, despite the presence of a contemporaneous competitiveness term. The INFLPR coefficient is significantly less than unity.

(3) The coefficients of the fiscal variables turned out to be statistically significant, albeit, as expected, lower relative to the estimates of the equation using INFL as proxy for INFLPR. The fiscal position appears to affect long–term interest rate differentials independently of its impact on inflationary expectations.

(4) The DEV coefficient turns out to be significant and positive, suggesting that a decision to devalue generates expectations of a recourse to this measure in the future as well. Other things being equal, a 10 percent devaluation of the BF results in a 1.9 percent rise in the Belgian– German long–term interest rate differential over the next three quarters.

(5) The REG coefficient turns out to be positive and significant, suggesting that the announcement of the “franc fort” policy contributed to the narrowing of the Belgian–German interest rate differential by 0.5 percent.

Figure 4. Adjusted Interest Rate Corridors

(6) Finally, the COMP* TIME coefficient turns out to be statistically significant and opposite in sign to the COMP coefficient, suggesting that the monetary authorities have been perceived as progressively less willing to offset past losses in competitiveness through exchange rate adjustment.

Because of the above observations, and particularly because the significance of the fiscal variables appears to extend beyond their impact on expected exchange rate movements, the interest rate corridors are now adjusted to test exchange rate credibility (Figure 4). In contrast to the results of Section I, long–term exchange rate credibility from 1990 onward can no longer be rejected.^{6} The fact that the Belgian bond yield has remained above the corridor analyzed in Section I can be explained by credit risk rather than exchange rate risk since 1990.

These conclusions turn out to be robust with respect to a number of alternative specifications.^{7} In particular, including the domestic and foreign components of debt separately to take into account the probable differences in the incentive to monetize associated with each one left the interest rate corridors of Figure 4 virtually unchanged. Furthermore, consideration of a number of additional independent variables, such as unemployment and the external balance, suggested that these have no explanatory power with regard to interest rate differentials.^{8} Consideration of a richer lag structure, derived from partial adjustment models, also had no impact on the conclusions.

Finally, the estimates of credit risk obtained from the above equation can be compared with alternative credit risk indicators, namely, Belgian– German yield differentials on government bonds denominated in deutsche mark and U.S. dollars. Although these indicators are hampered by data gaps and market illiquidity, they tend to fall within the 95 percent confidence interval for credit risk obtained from a constrained version of the above regression. Even if the lower bound of the confidence interval is used to adjust the interest rate corridor in Figure 4, the conclusions would not be significantly affected; the only difference is that nonrejection of the credibility hypothesis would be attained one quarter later.

## V. Summary and Policy Implications

The purpose of this paper was to test the credibility of Belgium’s exchange rate policy, particularly because simple interest rate corridor analysis indicates that long–term credibility has yet to be achieved, despite substantial progress in this area.

To this end, the determinants of long–term interest rate differentials were examined. The main conclusion was that fiscal variables appear to affect the interest rate differentials quite independently of their impact on inflationary expectations, and hence on anticipated exchange rate movements, thus raising questions about the assumption of interest rate parity, at least insofar as expected exchange rate movements exclusively reflect expected inflation differentials. The interest rate corridors were adjusted accordingly, and it was concluded that long–term credibility can no longer be rejected.

The specific formulation of inflationary expectations chosen is somewhat arbitrary, despite its appealing features. A particular shortcoming is that this formulation does not take into account the impact of announced future policies. A more fundamental question is whether the fiscal variables may affect expected exchange rate changes through channels other than inflationary expectations.

The importance of fiscal variables in affecting long–term interest rate differentials can be quantified in a straightforward way: given the current fiscal position, the estimation results suggest that the primary surplus must rise to about 8 percent of GDP for Belgium to attain long–term interest rate equalization relative to Germany. This estimate is conservative, as it presupposes that Belgium’s inflation will remain below Germany’s over the near future.

Even though the breakdown of the impact of the fiscal variables into an effect that works through expected exchange rate movements and an effect related to credit risk may not be of practical significance for the overall interest rate differential per se, it is sufficiently important to be worth pursuing. In addition to its relevance for the problem of optimal debt financing, it also indicates that long–term interest rate differentials may persist, even if the ERM becomes more credible over time, or indeed after the introduction of a single European currency.

Thus, the analysis highlights the importance of fiscal consolidation as a policy priority, as the current fiscal imbalances are contributing to the persistence of the long–term interest rate differential vis–à–vis Germany. The findings suggest that this effect works through two main channels: (1) the impact of the fiscal variables on inflationary expectations, reflecting the perceived incentive of the authorities to monetize the large public debt and (2) a credit risk component.

This paper had been largely completed before the decision to widen the EMS band from 2.25 percent to 15 percent was reached in August 1993. Although the new band, if fully exploited, may arguably be regarded as effectively equivalent to floating for most EU currencies, the analysis of exchange rate credibility largely retains its relevance. First, the widening of the band was conceived as a temporary measure in response to the currency turmoil, with the aim of re–establishing the narrow band in the future. Second, and perhaps more important, it is not too likely that a small, open economy like Belgium would opt for pure floating— even during the transition period of the wider fluctuation band. In fact, the Belgian monetary authorities’ policy response to the widening of the band was to raise short–term rates, while indicating that they would pursue a policy of unilaterally pegging the Belgian franc close to its old band vis–à–vis the deutsche mark. Under these conditions, although the results in this paper on exchange rate credibility may be sensitive to some extent to the institutional framework—particularly with regard to inter-vention by other EMS central banks that is now mandatory only when a currency reaches the boundary of its 15 percent band—they can still shed some light on the feasibility of unilaterally pegging the exchange rate without reintroducing capital controls.

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Caramazza, Francesco,“French–German Interest Rate Differentials and Time– Varying Realignment Risk,”Staff Papers, International Monetary Fund, Vol. 40 (September1993), pp. 567–83.

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Ioannis Halikias, an Economist in the European I Department, holds an M.Phil. in economics from Yale University. The author thanks Francesco Caramazza, Paul Masson, and Hari Vittas for helpful comments and Susan Becker for research assistance.

The interest rate corridor method was introduced by Svensson (1991) for the Swedish krona. It was applied to the Belgian franc by Koen (1991).

However, uncertainty over the constitutional future of Belgium, and the related recent proposals to allocate the central government debt to the regional governments could be relevant sources of credit risk. For a discussion of these issues, see the central bank’s views as reported in the Belgian daily *L’Echo* (1992).

A rise in COMP signifies an improvement in relative competitiveness.

The results are not affected if the COMP variable is replaced by the Belgian– German ratio of the level of competitiveness, as defined by the respective real effective exchange rate indices.

On the other hand, Radaelli’s (1988) study of European onshore–offshore interest rates, suggesting that the markets have been reasonably accurate in forecasting the timing of realignments, can be interpreted as an indication that the bias resulting from the peso problem may have been rather small. Also, Dornbusch (1989) points to the flatness of the yield curve, which became inverted for many EMS countries, including Belgium, after 1990, as evidence that the peso problem may not he substantial.

The timing of the attainment of exchange rate credibility coincides almost exactly with the announcement of the “franc fort” policy.

The relevant results are available from the author upon request.

This result can be contrasted with Caramazza’s (1993) conclusions for France, which suggest that the authorities’ exchange rate policy is perceived to be influenced by the level of the unemployment rate and, to a lesser extent, by the change in foreign exchange reserves.