European Monetary System (Organization) ; Foreign exchange rates

Andrew K. Rose

English

Research Papers in Economics

FABSF WEEKLY LETTER
Number 93-18, May 7, 1993
European Exchange Rate Credibility
before the Fall: The Case of Sterling
In September 1992 the European Monetary Sys-
tem faced a currency crisis. The eleven countries
participating in the Exchange Rate Mechanism
(ERM), which involves maintaining cross-rate
pegs to each others' currencies, experienced a
series of speculative attacks on their currencies.
Within a single week, these attacks forced two
devaluations and, more importantly, forced the
Italian lira and the British pound sterling to drop
out of the ERM altogether; these two currencies
have been floating since then.
Most onlookers agree that the ultimate source
of the crisis was macroeconomic in nature. It
stemmed from the high fiscal cost of German
unification combined with the unwillingness of
Germany's central bank to ease monetary policy
in order to accommodate this expansionary fiscal
policy (see the Weekly Letter of October 16,
1992). The immediate causes ofthe currency
crisis, however, are not as clear. It is sometimes
asserted that the underlying macroeconomic
problems led speculators to doubt the credibility
of European monetary authorities--that is, as the
size of the underlying problems became appar-
ent, credibility slowly diminished, a process that
culminated in the currency crisis.
In this Letter, I investigate whether private finan-
cial market participants anticipated the currency
crisis, and therefore doubted the credibility of
the ERM, long before the system was actually at-
tacked. I define a highly credible fixed exchange
rate as one which the financial markets do not
expect to change and an exchange rate with low
credibility as one which the financial markets ex-
pect to be devalued. More precisely, I estimate
and interpret quantitative measures of the credi-
bilityof European exchange rates, focusing on
the period before "Black Wednesday," September
16, 1992, when the pound and the lira were
forced to drop out ofthe ERM. I place particular
emphasis on the case of the British pound during
1992. The pound is an intrinsically interesting
case, since the British government, which has
more direct control of monetary policy than most
other ERM members, was highly committed to
maintaining the pound within the ERM.
The expectation of a sterling realignment is esti-
mated using the "drift adjustment" technique,
described in Rose and Svensson (199,2). This
technique distinguishes the "normal" movement
of a currency around its peg from the more pro-
nounced interest rate movements that would
signal the expectation of realignment. Thus, the
measures estimated reflect the private financial
markets' assessment of the credibility of fixed
exchange rate regimes.
The chief finding is that sterling's peg appeared
to be credible throughout much of 1992. Indi-
cations that the market expected a realignment
did not become really significant until September
1992, immediately before the crisis. Thus, there
is no evidence that British and Italian policymak-
ers reacted tardily to a situation that was clearly
seen by financial markets as critical; rather, both
policymakers and the financial markets were
taken by surprise. This conclusion holds for the
other currencies in the ERM as well.
Interest differentials
and exchange rate expectations
As a member of the ERM, the UK committed
itself to keeping its exchange rate vis-a-vis
Germany, as well as the other members, close
to "central parity" rates chosen when the UK
entered the ERM in 1990. The first signs of
a breakdown in that commitment, that is, of a
realignment of the pound, would have appeared
in the difference between interest rates in the
UK and in Germany. If British interest rates were
higher than German interest rates for comparable
securities, investors would expect a depreciation
of sterling vis-a-vis the OM; otherwise the return
on British and German assets would differ and
investors would not hold both securities. Thus,
the interest rate differential is a measure of the
expected rate of change of the exchange rate,
and it is the first place to look for indications of
an expected sterling real ignment.Figure 2
Expectations of a 5% Sterling Realignment
Figure 2 graphs expectations of a sterling rea-
lignment, that is, the interest differential after
adjusting for expected daily exchange rate drift
within the band. The graph plots an expected
realignment of 5 percent (a reasonable guess,
given the traditional size of ERM realignments)
calculated using data over the period of sterling's
participation in the ERM, October 1990 through
September 1992. The vertical axis indicates the
expected timing of the realignment times its ex-
pected size. Therefore, to find the probability
ofa 5 percent realignment in the next month,
divide the measure by 12; for example, In Octo-
ber 1990, the measure was 2, and 2/12 equals
about a 17 percent probability of a 5 percent
realignment. Adjusting interest differentials for
expected exchange rate drift clearly leads to a
more volatile and accurate measure of realign-
ment expectations. (Again different maturities
yield similar information.)
toward themiddle again, that is, to depreciate
somewhat. This expected depreciation within the
band could fully, or more than fully/account for
the total expected depreciation manifest in the
interest differential. This suggests that interest
rate differentials (the expected total exchange
rate change) should be adjusted to take into ac-
countexpected exchange rate drift within the
band (using the "drift adjustment" technique) in
order toyield a measure of realignment expec-
tation5 (expectations of a change in the central
parity). If this measure is high, then the exchange
rate central parity is expected to be devalued,
that is, the exchange rate peg is not credible.
Clearly, higher realignment expectations are as-
sociated with expectation of a bigger or faster
realignment (or both). Conversely, a negative
value indicates expectations of a sterling reval-
uation (against the Deutschemark).
4.0
2.0
6.0
September
1992
-2.0
Figure 1 plots the difference between British
and German interest rates for three-month Euro-
securities from steriing'sERM entry in October
1990 through the end ofOctober 1992. The verti-
cal line marks BlackWednesday, the daysterling
dropped out of theERM. Clearly, interestrate dif-
ferentials fell virtually continually after the UK
joined the ERM. They rose only briefly in mid-
September 1992, and even then only to modest
levels (both compared with the previous few
years and with other ERM participants). Thus,
the raw data on interest differentials give little
evidence that financial markets expected a ster-
ling realignment until immediately before Black
Wednesday. Interest rate differentials with both
longer and shorter maturities yield the same
conclusion.
-----------"-"'-'---t"1+ 0.0
Figure 1
Daily U.K.-German Interes~ Rate Differentials
Percent
rr-rTirn--rT-rT""T""'T"'T""T"'T""T""-"""-ro-1M-+ -4.0
Oct Jan Apr Jul Oct Jan Apr Jul Oct
1991 1992
FRBSF
Adjusting for Exchange Rate Drift
The Briti5h-German interest rate differential
remained low and positive throughout most of
1992; that is, the pound was expected to depre-
ciate, but only by a small amount. However, this
does not mean that the market viewed realign-
ment as being unlikely. Sterling was a "wide-
band" participant in the ERM; that is, its bilateral
DM rate could move by as much as 6 percent
around the central parity. But up until Black
Wednesday, it also tended to drift back to the
middle ofthe band fairly quickly after it had
been pushed to the edge. This behavior was com-
mon for the other ERM currencies as well. So, for
example, if sterling had appreciated to the strong
edge of the band, it was expected to drift back
Oct Jan Apr Jul Oct Jan Apr Jul Oct
1991 1992The derived series seems sensible; realignment
expectations were low right after sterling's ERM
entry but rose during the uncertainty surround-
ing the Conservative leadership conference of
November 1990 when Margaret Thatcher was
ousted as Prime Minister. Realignment expec-
tations then fell following John Major's victory
(which is not surprising, since he was instrumen-
tal in bringing the pound into the ERM), and re-
mained relatively low until the 1992 general
election. After the Conservative victory in the
general election of April 1992, realignment ex-
pectations fell off dramatically. The most impor-
tant message is that realignment expectations
were quite low during the immediate run-up
to August 1992. Realignment expectations in
mid-August 1992 were comparable to those
before the general election of April. Indeed, the
negative values during the early part of the sum-
mer of 1992 indicate that insofar as the market
expected any realignment, it was for a sterling
revaluation.
Evidence for other ERM participants
Figures 3 and 4 contain data on expectations of a
5 percent realignment for Italy and France since
January 1987, the date of the last serious ERM
realignment before 1992. Italy was forced out
of the ERM on Black Wednesday; while France
has not devalued since 1987, its currency was at-
tacked (and successfully defended) in September
1992; the case of France is similar to most of the
other ERM members.
Just as with realignment expectations for the
UK, the realignment measures for the other two
countries rose dramatically in the late summer of
1992. There were few serious expectations of a
European currency crisis until mid-August 1992
at the earliest (with the possible exception of the
lira). Perhaps even more interesting is the fact that
realignment expectations, even in the late sum-
mer of 1992,were comparable to those experi-
enced by ERM participants during the previous
five years of exchange rate tranquility. Thus,
there is little evidence from financial data that
the ERM in the late summer of 1992 was in a
period without historical precedent. Rather, most.
interest and exchange rate data indicated "busi-
ness as usual."
Summary
This Letter has used daily data to measure the
expectations of financial markets concerning
future ERM realignments. The empirical tech-
nique adjusted interest rate differentials by the
Figure 3
Expectations ofa 5% Lira Realignment 6.0
2.0
0.0
-2.0
,--,---..,--.,---,----r---+ -4.0
1987 1988 1989 1990 1991 1992
Figure 4
Expectations ofa 5% Franc Realignment 6.0
4.0
2.0
0.0
-2.0
-4.0
1987 1988 1989 1990 1991 1992
expected drift of exchange rates within ERM
bands. Two substantive points emerged. First,
expectations of a sterling realignment were low
throughout most of (1991 and) 1992, both ab-
solutely and relative to other ERM currencies.
Sterling's credibility was not in reasonable doubt
until mid-August 1992, at the earliest. Second,
the ERM (including sterling) had previously
weathered crises of the magnitude that markets
had expected even through early September
1992. In light of this evidence, it is hard to blame
European policymakers for reacting slowly to a
situation of growing tension, since there were
remarkably few indications of a brewing crisis.
Andrew K. Rose
Associate Professor, U.c. Berkeley
Visiting Scholar, FRBSF
Reference
Rose, Andrew K., and Lars E.G. Svensson. 1992.
"Expected and Predicted Realignments." Mimeo.
U.c. Berkeley.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors ofthe Federal Reserve System.
Editorial comments may be addressed tothe editor orto the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.OlL176 \I) 'OJSpueJ:I ueS
lOLL xog ·O·d
O)SI)UOJ~ UOS
JO ~U08
aAJaSa~ IOJapaj
~uaw~Jodaa 4)Joasa~
Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TiTlE AUTHOR
11/13
11/20
11/27
12/4
12/11
12/25
1/1
1/8
1/22
1129
2/5
2/12
2/19
2/26
3/5
3112
3/19
3/26
4/2
4/9
4/16
4123
4/30
92-40
92-41
92-42
92-43
92-44
92-45
93-01
93-02
93-03
93-04
93-05
93-06
93-07
93-08
93-09
93-10
93-11
93-12
93-13
93-14
93-15
93-16
93-17
NAFTA and u.s. Banking
A Note of Caution on Early Bank Closure
Where's the Recovery?
Diamonds and Water: A Paradox Revisited
Sluggish Money Growth: japan's Recent Experience
Labor Market Structure and Monetary Policy
An Alternative Strategy for Monetary Policy
The Recession, the Recovery, and the Productivity Slowdown
u.s. Banking Turnaround
Competitive Forces and Profit Persistence in Banking
The Sources of the Growth Slowdown
GDP Fluctuations: Permanent or Temporary?
The Twelfth District Agricultural Outlook
Saving-Investment Linkages in the Pacific Basin
A Single Market for Europe?
Risks in the Swaps Market
On the Changing Composition of Bank Portfolios
Interest Rate Spreads as Indicators for Monetary Policy
The Lonesome Twin
Why Has Employment Grown So Slowly?
Interpreting the Term Structure of Interest Rates
California Banking Problems
Is Banking on the Brink? Another Look
Laderman/Moreno
Levonian
Cromwell/Trenholme
Schmidt
Moreno/Kim
Huh
Motley/judd
Cogley
Zimmerman
Levonian
Motley
Moreno
Dean
Kim
Glick/Hutchison
Laderman
Neuberger
Huh
Throop
Trehan
Cogley
Zimmerman
Levonian
The FRBSF Weekly Letter appears on an abbreviated schedule in june, July, August, and December.

974-2246, Fax (415) 974-3341.OlL176 \I) 'OJSpueJ:I ueS lOLL xog ·O·d O)SI)UOJ~ UOS JO ~U08 aAJaSa~ IOJapaj ~uaw~Jodaa 4)Joasa~ Index to Recent Issues of FRBSF Weekly Letter

European exchange rate credibility before the fall: the case of sterling

http://www.frbsf.org/publications/economics/letter/1993/el93-18.pdf

European exchange rate credibility before the fall: the case of sterling

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics