Currency Crises and Political Factors: Drawing Lessons from the EMS Experience

Abstract

AbstractThis paper analyses the functioning of the European Exchange RateMechanism (ERM). To that end, we apply duration models to estimatean eclectic specification that enables us to explicitly incorporated politicaland institutional factors into the explanation of European exchange ratepolicies. The estimations are based on quarterly data of eight currenciesparticipating in the ERM, covering the complete history of the EuropeanMonetary System. Our results suggest that both economic and politicalfactors are important determinants of the ERM currency policies. Con-cerning economic factors, the real exchange rate, the interest differentialsand the central parity deviation would have negatively affected the dura-tion of a given central parity, while credibility, the level of internationalreserves and the price level in the anchor country would have positivelyinfluenced such duration. Regarding political variables, elections, centralbank independence and left-wing administrations would have increasedthe probability of maintaining the current regime, while unstable govern-ments would have been associated with more frequent regime changes.Moreover,weshowhowthepoliticalaugmented model outperforms, bothin terms of explanatory power and goodness of fit, the model which justincorporates pure economic determinants.JEL classification numbers: C41, D72, F31, F33Key Words: Duration analysis, Political variables, Exchange rates, Eu-ropean Monetary System