This paper provides empirical evidence on the determinants of exchange rate credibility under the European Monetary System (EMS). To that end, we have considered both economic variables and political factors using data of eight currencies participating in the Exchange Rate Mechanism, covering the complete EMS history (1979-1998). Our results suggest that the level of international reserves, the real interest rate and right-wing governments would have positively affected the credibility of a given central parity, while the unemployment rate and the inflation rate would have negative influenced such credibility.Credibility, Political variables, Exchange rates, European Monetary System

Francisco Ledesma-Rodríguez

Jorge Pérez-Rodríguez

Simón Sosvilla-Rivero

English

Research Papers in Economics

DOCUMENTOS DE ECONOMIA Y
FINANZAS INTERNACIONALES
Asociación Española de Economía y Finanzas Internacionales
http://www.fedea.es/hojas/publicaciones.html
ISSN 1696-6376
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An empirical examination of exchange-rate
credibility determinants in the EMS
Francisco Ledesma-Rodríguez
Jorge Pérez-Rodríguez
Simón Sosvilla-Rivero
March 2004
DEFI 04/01An empirical examination of exchange-rate credibility determinants in the EMS
*
March 2004
Francisco Ledesma-Rodríguez
(Universidad de La Laguna)
Jorge Pérez-Rodríguez
(Universidad de Las Palmas de Gran Canaria)
Simón Sosvilla-Rivero
(FEDEA and Universidad Complutense de Madrid)
______________________________________________________________________
ABSTRACT
This paper provides empirical evidence on the determinants of exchange rate
credibility under the European Monetary System (EMS). To that end, we have
considered both economic variables and political factors using data of eight currencies
participating in the Exchange Rate Mechanism, covering the complete EMS history
(1979-1998). Our results suggest that the level of international reserves, the real interest
rate and right-wing governments would have positively affected the credibility of a
given central parity, while the unemployment rate and the inflation rate would have
negative influenced such credibility.
JEL classification numbers: C32, D72, F31, F33,
KEY WORDS: Credibility, Political variables, Exchange rates, European Monetary
System.
______________________________________________________________________
Corresponding author:
Simón Sosvilla-Rivero
FEDEA
Jorge Juan, 46
28001 Madrid
Spain
Tel:+34-91-435 04 01
Fax:+34-91-577 95 75
e-mail:simon.sosvilla@fedea.es
                                                
* The authors thank José Viñals (Bank of Spain) who gave us access to the data on exchange rates and
interest rates used in this paper.2
1.  Introduction
The European Monetary System (EMS) was initially planned as an agreement to
reduce exchange rate volatility for a Europe in transition to closer economic and
possibly political integration, as well as an attempt to foster economic integration and
the co-ordination of economic policies in the now European Union (EU).
The centrepiece of the EMS was the Exchange Rate Mechanism (ERM), an
adjustable peg system in which each participating country was assigned a specific range
(target zone) within it its exchange rate could fluctuate with respect to the others. In
order to keep the exchange rates within these margins, the participating countries were
obliged to intervene in the foreign exchange market whenever their currency
approached the limits of its band. Realignment of the parities by the monetary
authorities was possible, provided that all the members of EMS agreed.
Following Krugman (1991), a growing theoretical literature has attempted to explain
exchange rate movements inside official fluctuation bands such as those of the ERM
with the help of target zone models (see Kempa and Nelles, 1999, for a review). The
main result of the target zone model is that, with perfect credibility, the zone exerts a
stabilising effect (the so-called ''honeymoon'' effect), reducing the sensitivity of
exchange rates to a given change in fundamentals. Nevertheless, in a target zone with
credibility problems, expectations of future interventions tend to destabilise the
exchange rate (the so-called ''divorce'' effect), making it less stable than the underlying
fundamentals (Bertola and Caballero, 1992).
Therefore, credibility becomes a key issue in examining the behaviour of a target
zone agreement such as the ERM, since the possibility that the official authorities
change the central parity could be anticipated by the economic agents, triggering
expectations of future changes in the exchange rate that could act as a destabilising
element of the system. In this context, credibility refers to the perception of economic
agents with respect to the commitment to maintain the exchange rate around a central
parity.
The aim of this paper is to provide empirical evidence on the determinants of
exchange rate credibility using data covering the ERM history. As  ERM credibility3
varied over time as well as among European countries, we evaluate the influence of
both economic variables and political factors that might help explain such behaviour.
2. ERM credibility and its potential determinants
2.1. Measuring credibility
There are several credibility measures that have been used in the empirical
literature. Svensson (1991) presented a simple test to study the credibility of a target
zone exchange rate regime with fluctuation bands. Bertola and Svensson (1993) propose
the so-called the drift-adjustment method” to estimate realignment expectations that
constitute an inverse measure of credibility. Edin and Vredin (1993) employ models of
discrete to estimate the probability of realignment, using explanatory variables such as
the interest rate differential, the inflation differential, the current account balance, and
the unemployment rate.
 Ledesma-Rodríguez et al. (2003) compare theses available indicators according
to their ability to detect the main events in the history of the ERM. Their results suggest
that marginal credibility is the best indicator in order to capture true signals of
realignments and not to convey false signals. This credibility measure was originally
proposed by Weber (1991). It focuses on the ability of policy announcements to
influence the public’s expectations, trying to measure the impact of official
announcements on exchange rates. It may be thought of as the weight placed on the
announcement when the public forms their expectations. Given this evidence, we take
marginal credibility as our credibility indicator, noting that, by construction, it
recognises the changing nature of the history of the ERM.
2.2. Economic determinants
In order to identify those economic variables that can influence the exchange-
rate credibility, we make use of the literature on currency crises [see Sosvilla-Rivero
and Pérez-Bermejo (2003) for a recent survey].  In particular, we consider the following
variables as a potential economic factors influencing the credibility of a given central
parity:
•  The level of international reserves (RES): The empirical evidence suggests that
increases in the level of international reserves significantly reduces the probability4
of a regimen change, enhancing the credibility of a given parity. We use data from
the IFS (line 1l.d).
•  The unemployment rate (U): An increase in this variable would signal weaker
economic performance and then would increase the pressure on the domestic
currency, leading to credibility losses. We use data from the IFS (line 67r).
•  The inflation rate (INF): The higher the inflation rate, the likelier a devaluation.
Therefore, one would expect a negative association between the inflation rate and
credibility. In particular we use data on consumer price index  from the IFS (line
64).
•  Real interest rate (RIR): An increase in this variable would indicate lower risk of
devaluation, and therefore would reduce the probability of future realignment,
positively affecting the credibility a given parity.  In particular we use data on long-
term interest rate kindly provided by the Bank of Spain.
2.3. Political factors
There is a large and growing literature on political-economic analysis of
monetary policy, but its application to exchange rates is almost non-existent
1.
Theoretical models in this literature fall basically into two categories: partisan and
opportunistic. Partisan models stress the different parties´ preferences over inflation and
unemployment, with right-wing government more likely to be concerned with fighting
inflation and maintaining price stability [see, e. g. Hibbs (1987) and Alesina (1989)]. To
captures partisan effects we use the variable PAR, defined as right-wing parties in
percentage of total cabinet posts, weighted by days (Armingeon, Bayeler and Menegale,
2002).
3. Empirical results
We use data from eight ERM countries (Belgium, Denmark, France, Ireland,
Italy, the Netherlands, Portugal and Spain). Data restrictions on political variables led us
to use annual data. Given the central role of Germany in the European Union (see, e. g.,
Bajo-Rubio et al., 2001), our exchange-rate credibility indicators are expressed in terms
of the Deutschmark. The sample period runs from 1979 to 1998 (160 observations),
covering the complete EMS history.5
We estimate with cross-section weights feasible generalised least squares
(FGLS) using White heteroskedasticity covariance, allowing for variances within a
cross-section (countries) to differ across time. Table 1 reports the estimation results.
As can be seen, on one hand all the economic variables which theory suggest
affects exchange-rate credibility are statistically significant at the 5% level (except for
the unemployment rate which is significant at the 10%) and the signs of the estimated
coefficients have the expected signs.  On the other hand, and in line with the prediction
of the Partisan theory, right-wing governments would have increased the credibility of a
commitment to maintain a given central parity.
In order to check the robustness of our results to changes in the sample, we have
analysed the sensitivity of the estimated coefficients to the exclusion of each country
one at a time. As can be seen in Table 2, the estimated coefficients remain relatively
constant, except for RES when excluding Belgium, for U when excluding Belgium,
France, Ireland, the Netherlands and Spain, for INF when excluding Denmark and
Ireland, and PAR when excluding Denmark, Ireland, Portugal and Spain. Nevertheless,
it is interesting to note that all the parameters are within the 95% confidence interval we
have estimated in Table 1, except for U when excluding Belgium and Spain, and for
PAR when excluding Denmark. Therefore, this evidence can be taken as suggesting that
our results are based on a relatively homogeneous sample of countries. Finally, note that
when excluding Ireland, all the variables are statistically significant at the 1% level.
References
Alesina, A., 1989. Politics and business cycles in industrial democracies. Economic
Policy 8, 55-89.
Alogoskoufis, G., Lockwood, B., Philippopoulos, A., 1992. Wage inflation, electoral
uncertainty and the exchange rate regime: Theory and UK evidence. Economic
Journal 102, 1370-1394.
                                                                                                                                              
1 The exception being Alogoskoufis et al. (1992), who present a model of exchange-rate policy for the
UK, and Drazen (2000) who explains contagion in the exchange rate crises based on political factors.6
Armingeon, K. Bayeler, M., Menegale, S., 2002. Comparative political data set,
Institute of Political Science, University of Bern.
Bajo-Rubio, O., Sosvilla-Rivero, S., Fernández-Rodríguez, F., 2001. Asymmetry in the
EMS: New evidence based on non-linear forecasts. European Economic Review
45, 451-473.
Bertola, G., Caballero, R.J., 1992. Target zones and realignments. American Economic
Review 82, 520-536.
Bertola, G., Svensson, L.E.O., 1993. Stochastic devaluation risk and the empirical fit of
target zone models. Review of Economic Studies 60, 689-712.
Drazen, A., 2000. Political Contagion in Currency Crises. In: P. Krugman (ed.),
Currency Crises. University of Chicago Press, Chicago.
Edin, P.-A., Vredin A., 1993. Devaluation risk in target zones: Evidence from the
Nordic countries. Economic Journal 103, 161-175.
Hibbs, D., 1987. The American political economy. Macroeconomic and electoral
politics. Harvard University Press, Cambridge, Mass.
Kempa, B., Nelles, M., 1999. The Theory of Exchange Rate Target Zones. Journal of
Economic Surveys 13,173-210.
Krugman, P., 1991. Target zones and exchange rate dynamics. Quarterly Journal of
Economics 106,  669-682.
Ledesma-Rodríguez, F., Navarro-Ibañez, M., Pérez-Rodríguez, J., Sosvilla-Rivero, S.,
2003. On the credibility of a target zone: Evidence from the EMS, centrA
Working Paper E2003/33 (available at http://www2.fundacion-
centra.org/pdfs/E200333.pdf).
Sosvilla-Rivero, S., Pérez-Bermejo, F., 2003. Credibility and duration in target zones:
Evidence from the EMS", FEDEA Working Paper 2003-18 (available at
ftp://ftp.fedea.es/pub/Papers/2003/dt2003-19.pdf).
Svensson, L.E.O., 1991. The simplest test of target zone credibility. IMF Staff Papers
38,  655-665.
Weber, A., 1991. Reputation and credibility in the European Monetary System.
Economic Policy 12, 58-102.7
Table 1. Estimation results
Coefficient t
RES 0.0722 3.1679
U -0.0039 -1.7838
INF -3.5854 -3.0185
RIR 0.0238 9.0249
PAR 0.0278 2.2297
2 R 0.9913
Log-likelihood 243.66
Note: For space considerations, we do not report the estimates of the country fixed
effects.
Table 2: Sensibility analysis to country exclusion
RES U INF RIR PAR
NONE 0.0722
(3.1679)
-0.0039
(-1.7838)
-3.5854
(-3.0185)
0.0238
(9.0249)
0.0278
(2.2297)
BELGIUM 0.1026
(1.9346)
-0.0076
(-2.1873)
-3.5135
(-1.2708)
0.0296
(6.2174)
0.0289
(1.5027)
DENMARK 0.0610
(1.9537)
-0.0034
(-1.1812)
-2.7746
(-1.7109)
0.0260
(6.3967)
-0.0010
(-0.3254)
FRANCE 0.0701
(2.6422)
-0.0062
(-2.7378)
-3.7170
(-2.8143)
0.0256
(11.6299)
0.0237
(1.7447)
IRELAND 0.0579
(2.6504)
-0.0082
(-5.3780)
-4.5501
(-4.2968)
0.0265
(15.066)
0.0341
(3.3225)
ITALY 0.0642
(3.0070)
-0.0041
(-1.6672)
-3.6649
(-3.0827)
0.0221
(5.1895)
0.0221
(1.9018)
NETHERLANDS 0.0803
(3.0156)
0.0014
(0.4840)
-3.4705
(-2.4811)
0.0245
(9.9955)
0.0252
(1.7794)
PORTUGAL 0.0757
(3.3622)
-0.0040
(-1.7794)
-3.2357
(-2.4865)
0.0212
(4.5877)
0.0331
(2.4816)
SPAIN 0.0718
(3.3279)
0.0027
(0.9070)
-3.5143
(-3.1076)
0.0211
(8.5409)
0.0129
(1.0145)
Note: t-values in parenthesis

1 The exception being Alogoskoufis

Asymmetry in the EMS: New evidence based on non-linear forecasts.

Credibility and duration in target zones: Evidence from the EMS&quot;, FEDEA Working Paper

Devaluation risk in target zones: Evidence from the Nordic countries.

On the credibility of a target zone: Evidence from the EMS, centrA Working Paper E2003/33 (available at http://www2.fundacioncentra.org/pdfs/E200333.pdf).

Political Contagion in Currency Crises.

Politics and business cycles in industrial democracies.

Reputation and credibility in the European Monetary System.

Stochastic devaluation risk and the empirical fit of target zone models.

Target zones and exchange rate dynamics.

Target zones and realignments.

The American political economy. Macroeconomic and electoral politics.

The simplest test of target zone credibility.

The Theory of Exchange Rate Target Zones.

Wage inflation, electoral uncertainty and the exchange rate regime: Theory and UK evidence.

An empirical examination of exchange-rate credibility determinants in the EMS

http://www.aeefi.com/RePEc/pdf/defi04-01.pdf

An empirical examination of exchange-rate credibility determinants in the EMS

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