Since the Realignment of currencies in the exchange rate mechanism (ERM) of the European Monetary System (EMS) in January 1987, the differential between French and German interest rates has narrowed considerably.1 Nevertheless, the continuing existence of a differential suggests that market participants do not rule out a realignment of central parities in the EMS before exchange rates are irrevocably fixed in the final stage of economic and monetary union (EMU). Specifically, the positive interest rate differential in favor of Germany across the maturity spectrum implies a perceived risk of devaluation of the franc-mark exchange rate. Indeed, attempts to quantify the various factors that might explain the French-German interest rate differential find that they account for only part of the differential.2
The persistence of a positive interest rate differential suggests that an announced commitment to a fixed exchange rate may not be sufficient to eliminate devaluation risk completely. Economic performance and the authorities’ policy approach also influence investors’ expectations. Thus, exchange rate policy may not be fully credible if, for instance, problems of unemployment, a weak external position, or other perceived weaknesses cast doubt on the authorities’ ability to maintain their commitment. In the same vein, a policy of keeping the exchange rate close to the upper (weak) edge of the fluctuation band may also diminish credibility.
This paper examines expectations of a realignment of the franc-mark central parity over the period February 1987 to November 1991. The aim is to estimate the expected rate of realignment and to attempt to identify the factors that might influence market participants’ expectations of parity changes.
A commonly used measure of the expected rate of realignment of a currency is the differential between the interest rates on assets denominated in the domestic currency and those denominated in a foreign currency. This measure is imprecise, however, especially for interest rates at the short end of the maturity spectrum, because interest rate differentials are affected by expected exchange rate changes within the fluctuation band of the exchange rate mechanism. In what follows, estimates of the time-varying expected rate of realignment are first constructed by adjusting interest rate differentials on 3-, 6-, and 12-month Eurofranc and Euromark deposits for the expected rate of change of the franc-mark exchange rate within the fluctuation band. The latter, in turn, is obtained by assuming that the exchange rate inside the band follows a mean-reversion process. The calculated expected parity changes are then regressed on a number of macroeconomic variables that agents are thought to consider in forming expectations of a currency’s possible realignment. A similar analysis is also conducted with long-term government bond yields. Inflation differentials, competitiveness, unemployment rates, relative fiscal situations, and the position of the exchange rate within the band are found to play an important role in the formation of exchange rate expectations.
Consumer prices: IMF, International Financial Statistics, line 64.
Exchange rates: IMF, average of daily observations.
Export prices: IMF, International Financial Statistics, line 74.
Foreign exchange reserves: IMF, International Financial Statistics, line 11.d (total reserves minus gold).
Gross domestic products: IMF, International Financial Statistics, line 99b.c for France, line 99a.c for Germany (monthly values obtained by interpolating from industrial production index).
Government financing requirements: IMF, International Financial Statistics, line 84.
Industrial production indices: IMF, International Financial Statistics, line 66c.
Interest rates (Euromarket rates): IMF; 7-10 year government bond yields:
Banque de France (average of daily observations). Unemployment rates: OECD, Analytical Data Base.
Andersen, Torben M., and Jan Rose Sorensen, “Exchange Rate Risks, Interest Rates and European Monetary Integration,” Memo 1991-18 (Aarhus: Centre for International Economics, University of Aarhus, 1991).
Artus, Patrick, “Peut-on comprendre I’écart de taux d’éinteret entre la France et l’Allemagne?” Document de Travail No. 1992-01/E (Paris: Caisse de Depots et Consignations, 1992).z
Artus, Patrick, and others, “Transmission of U.S. Monetary Policy to Europe and Asymmetry in the European Monetary System,” European Economic Review, Vol. 35 (1991). pp. 1369 –84.
Bertola, Giuseppe, and Lars E.O. Svensson, “Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models,” NBER Working Paper No. 3576 (Cambridge, Mass.: National Bureau of Economic Research, 1991).
Chen, Zhaohui, and Alberto Giovannini, “Estimating Expected Exchange Rates Under Target Zones,” NBER Working Paper No. 3955 (Cambridge, Mass.: National Bureau of Economic Research, 1992).
Drazen, Allan, and Paul R. Masson, “Credibility of Policies Versus Credibility of Policymakers” (unpublished; Washington: International Monetary Fund, 1992).
Frankel, Jeffrey, and Steven Phillips, “The European Monetary System: Credible at Last?” NBER Working Paper No. 3819 (Cambridge, Mass.: National Bureau of Economic Research, 1991).
Geadah, Sami, Tapio Saavalainen, and Lars E.O. Svensson, “The Credibility of Nordic Exchange Rate Bands: 1987-91,” IMF Working Paper 92/3 (Washington: International Monetary Fund, 1992).
Giovannini, Alberto, “European Monetary Reform: Progress and Prospects,” Brookings Papers on Economic Activity 2 (1990), pp. 217 –91.
Koen, Vincent, “Testing the Credibility of the Belgian Hard Currency Policy,” IMF Working Paper 91/79 (Washington: International Monetary Fund, 1991).
Lindberg, Hans, Lars E.O. Svensson, and Paul, Soderlind, “Devaluation Expectations: The Swedish Krona 1982-1991,” Seminar Paper No. 495 (Stockholm: Institute for International Economic Studies, 1991).
Newey, Whitney K., and Kenneth D. West, “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix,” Econometrica, Vol. 55 (1987), pp. 703 –8.
Rose, Andrew K., and Lars E.O. Svensson, “Expected and Predicted Realignments: The FF/DM Exchange Rate During the EMS,” International Finance Discussion Paper No. 395 (Washington: Board of Governors of the Federal Reserve System, 1991).
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Francesco Caramazza, a Senior Economist in the Monetary and Exchange Affairs Department, was a Senior Economist in the European I Department when this paper was written. He holds a doctorate from Johns Hopkins University. The author would like to thank Michael Deppler, John Green, and Harilaos Vittas for helpful comments and Susan Becker for research assistance.
Short-term interest rate differentials widened sharply in September 1992 and in the months following the ERM crisis. Recently, short-term differentials have narrowed significantly.
This test of target zone credibility was first applied by Svensson (1990) to the Swedish krona and has since been applied to a number of currencies by Giovannini (1990), Koen (1991), and Geadah, Saavalainen, and Svensson (1992).
The regression of As, on st-1, three lags of Δ
on the rational expectations assumption that Et(st+m—st), conditional on no realignment, is equal to (st+m—st). In this case, the disturbance of the estimated equation would include the expectations error st+m—Et(st+m). The point to note is that, whether in two steps or simultaneously, estimation of the expected rate of realignment requires an estimate of the expected change in the exchange rate within the band. Tests of hypotheses of the determinants of expected changes in the central parity are thus joint tests of the expected changes in the exchange rate within the band. It should also be noted that the estimated standard errors are conditional on the estimated series of realignment risk.
Since numerous variables can be considered, the results reported in this section should be regarded as an examination of some plausible determinants of market expectations.
The unemployment rate is more appropriately measured with respect to its natural rate. But assuming that over the sample period the natural rate is constant, it makes no difference—except for the constant term—whether the actual unemployment rate or its deviation from the natural rate is used. In the regression using the 12-month Euromarket rates, for example, the estimated constant term is -0.95 when the natural rate is assumed to be 8.5 percent and -0.25 (and not significantly different from zero) when the natural rate is assumed to be 9 percent. In view of the uncertainty about the perceived value of the natural rate, and since it makes no difference for the other coefficients, the constant term is not reported.
Specifically, the dummy variable takes values of one when the franc-mark rate is in the top half of the intervention band, two when it is in the top quarter, and three when it is in the top eighth.
The estimated coefficients on the dummy variable (with r-statistics in parentheses) in equations using the 3-, 6-, and 12-month interest rates, respectively, are 1.205 (6.89), 1.00 (6.41), and 0.66 (5.33).
Regulations other than capital controls, political and default risk, information and transaction costs, and other factors may also introduce a wedge between domestic market and Euromarket rates. Changes in domestic market rates may, therefore, be due to actual or anticipated changes in these characteristics rather than in exchange risk. Empirically, however, capital controls have been found to constitute the major explainable component of spreads between Euromarket and domestic market rates.
The results in the preceding section indicate that the expected rate of mean reversion decreases as the horizon lengthens.