The emergence of intense pressures within the exchange rate mechanism (ERM) of the European Monetary System (EMS) in late 1992 and 1993 led to the suspension of two currencies, devaluations of three currencies, and a substantial widening of the fluctuation bands for most of the currencies of the ERM. The underlying causes of the recent currency turmoil attracted significant attention. Some have claimed that while sound economic policies were necessary, they were not sufficient to prevent speculative runs on currencies. Others have claimed that the speculative attacks were justified by the underlying economic fundamentals.
This paper estimates an extended speculative attack model of currency crises in an attempt to identify the roles of macroeconomic fundamentals and speculative factors in the recent and earlier currency crises in the European foreign exchange markets. Three approaches were used to estimate market expectations of devaluations and to calculate the probability of a regime change--either a discrete devaluation or a switch to flexible exchange rates--in a sample of five countries: Denmark, Ireland, and Spain, which are members of the ERM, and Norway and Sweden, which pegged their currencies to currency baskets or to the European currency unit (ECU). The first approach applies the probit technique to the basic speculative attack model, which calculates the probability of a regime change as a function of economic fundamentals (level of domestic credit, real effective exchange rates, foreign interest rates and price level, real output, unemployment rate, trade balance, and foreign reserves). This approach was used to evaluate whether a regime change was justified by economic fundamentals alone. Second, a version of the Bertola and Swensson (1990) model was used to capture the existence of speculative pressures on these currencies which operate through interest rate differentials, the current position of the currency within its fluctuation band, and the level of foreign reserves. Finally, speculative proxies were combined with economic fundamentals to evaluate the combined impact of these factors on the probability of a regime change.
The empirical analysis shows that both economic fundamentals and speculative factors had a significant influence on the probability of regime changes for the sample countries. The analysis also confirms that the latest realignments in the European foreign exchange markets were mainly the result of foreign exchange market tensions amidst the growing conflict between the needs of the domestic economies and the policies needed to maintain fixed exchange rates. Market participants perceived that the existing parities of the currencies in these five countries were inconsistent with their underlying economic fundamentals, regardless of the source of their deterioration, at the time of realignment. Furthermore, defensive interest rate policies to maintain existing parities have proved ineffective, as the market perceived such policies to be inherently unsustainable.