Comparing Exchange Market Pressure across Five African Countries

Abstract

This paper compares the credibility of exchange rate arrangements for the five African countries which are members of the Community of Portuguese Speaking Countries and will be referred to as Afro-Luso. Our working hypothesis is that credibility necessarily implies low mean exchange market pressure (EMP), low EMP conditional volatility and low-severity EMP crises under financial-market integration. In addition, economic fundamentals must account for EMP dynamics. We also seek evidence of a risk–return relationship for mean EMP and of “bad news” (negative shocks) having a greater impact on EMP volatility than “good news” (positive shocks). Using our econometric models, we are able to rank Afro-Luso countries’ conditional volatility in ordinal terms. Our main conclusion is that countries with currency pegs, such as Guinea-Bissau (GB) and Cape Verde (CV), clearly have lower volatility when compared to those with managed floats and are therefore more credible. Moreover, EMP crises episodes under pegs are much less severe. We find that economic fundamentals correctly account for mean EMP in all countries and that the risk–return relationship is much more favourable for investors under currency pegs, as the increase in volatility is lower for the same rate of return. The exception to this finding is Mozambique (MOZ), which apparently has a risk–return profile akin to that enjoyed by countries with pegs. A plausible reason is that MOZ has the only managed float in our sample implementing monetary and exchange rate policy within the confines of an IMF framework, which establishes floors for international reserves and ceilings for the central bank’s net domestic assets. This intuition needs to be tested, however. EMP conditional volatility, meanwhile, is generally driven by changes in domestic credit (lowers it) and foreign reserve changes (raises it). The first effect is more pronounced under currency pegs, but also under MOZ’s managed float. “Bad news” increases volatility more that “good news” only in the case of CV’s currency peg, which we take to be another sign of its credibility. A few striking cross-country comparisons also emerge in our analysis. Among countries with managed floats, Angola (ANG) has the most severe EMP crises, MOZ the least severe and Sao Tome & Principe (STP) lies between the two extremes but closer to MOZ.