Central Parity Research Articles

The Polish Zloty, 1990–1999: Success and Underperformance

Exchange-rate regimes in transition economies over the last decade have spanned the entire spectrum of possibilities, going from freely floating to permanently fixed (currency boards, DM-ization) through managed floats, preannounced crawling rates, and bands with or without intermittent adjustments. Such extreme diversity is due to differences in available foreign reserves and in initial macroeconomic imbalances (especially the presence of a monetary overhang in some transition economies) and to differences in government preferences between inflation and unemployment. Performance of alternative exchange-rate regimes is difficult to assess, (i) because performance can be mixed, (ii) because all exchange regimes if sustained have a tendency to validate themselves via their impact on inflation, and above all, (iii) because performance depends on the entire package of public policy instruments (fiscal, monetary, and structural) and on exogenous factors, as well as the exchange-rate regime itself. Poland (1990-1999) bears out these considerations. nitially (starting 1 January 1990) a fixed exchange rate was selected, pegged to the U.S. dollar at the then-prevailing free-market rate; it was backed by a $1,000 million stabilization fund provided by the G-24 which was not used but enhanced regime credibility. Monetary overhang had been virtually eliminated by earlier rounds of price increases and of zloty devaluations in 1989. Government preferences for disinflation assigned to the exchange rate the role of nominal anchor for the entire stabilization program. The fixed rate, expected to last no more than 3-4 months, in spite of massive inflation (249 percent in 1990 alone) was maintained until May 1991, when a 17-percent devaluation occurred and, the peg switched to a currency basket (full details are given in Table 1). Subsequently, concerns about externlc balance and the maintenance of trade competitiveness led to a crawling-peg regime, with intermittent additional devaluations, then to an increasingly broader band around a central parity crawling at rates progressively decreasing over time (see Table 1 and Figs. 1 and 2). As in every transition economy, the real exchange rate has been steadily revalued from an initial gross undervaluation. Unlike most transition economies, however, Poland gradually has been able to consolidate the exchange rate (see Fig. 1), stabilize the crawling regime, and even experience occasional nominal revaluations (see Fig. 2).

The ECB's Monetary Policy: Experience After the First Year

On 1 January 1999, 11 of the 15 Member States of the European Union adopted the euro as their single currency. The euro replaced the former national currencies on the basis of conversion rates that were irrevocably fixed on 31 December 1998. The task of defining and implementing the single monetary policy for the “euro area” has been assumed by the European Central Bank (ECB). The Governing Council and the Executive Board govern the Eurosystem, which is composed of the ECB and the 11 national central banks (NCBs) of the participating EU Member States. The ECB and the 15 NCBs of the EU Member States form the European System of Central Banks (ESCB). The transition to the single currency has required substantial preparatory work. The European Monetary Institute and the NCBs of the EU Member States started at a very early stage to do contingency planning on a number of crucial issues related to the monetary union: from the details of the announcement of central parities to preliminary evaluations of alternative monetary policy strategies. This considerable effort was criticized by sceptics, pointing out the alleged economic inadequacy of the Maastricht criteria, the risks of an early announcement of the conversion rates, and so on and so forth. It is fair to recognize, however, that no hint of turbulence or increase of volatility was recorded in foreign exchange markets between the announcement of the conversion rates, in April 1998, and the beginning of the monetary union.

Van devaluatie tot euro : Het economische en meer bepaald het monetaire beleid van België 1980-2000

This article on the evolution of economic and monetary policy in Belgium, which turned the "sick man of Europe" into one of the stronger European economies and allowed it to enter into EMU, stresses the role of the monetary authorities as a stabilising force in Belgium. It gives a detailed analysis of how these changes have allowed Belgium to regain the confidence of both monetary authorities and international investors after the devaluation of 1982. The policy responses to the oil shock at the beginning of the seventies broke with the policy mix which had until then been practised. Both the wage formation process andf iscal policy clearly spiralled out of control, the chiefresult of which was a drastic loss in international competitiveness. As a consequence, the current account showed a large deficit, the traditional level at which public deficit had stood rose dramatically, unemployment exploded and the financial structure of most corporations became fragile.A drastic realignment of economic policy started with the devaluation of the Belgian franc in 1982. This devaluation was accompanied by a series of measures aimed at preventing the inflationary pressures from triggering further devaluations, and hence at restoring credibility. These measures included restrictive fiscal policies (tax increases and cuts inpublic spending) and real wage cuts. By 1987 this recovery policy had successfully restored Belgian competitiveness, reduced the government deficit and restored the balance ofpayments equilibrium. Although public policies became less restrictive during the period 1988-1993, the central bank continued to gain international credibility. Significant stepsin this process were the abolition of the dual exchange rate system, the decision to peg the Belgian franc to the most stable currency in the ERM (i.e. the German mark) and the reform of the money markets in Belgium. The latter in particular helped to increase the central bank's independence, since this reform implied total control by the central bank over short term interest rates, it reduced significantly the automatic credit lines of the fiscal authorities with the central bank and it stipulated that revaluations of gold reserves should no langer be used to finance government budget deficits. By 1992 international credibility had been restored to such a degree that the Belgian franc became a strong currency during the 1992 crisis, obliging the central bank to come to the rescue of the weaker currencies under attack in September 1992 with a speculative inflow of capital of about 200 billion BEF. However this restored credibility continued to be fragile, as became evident during the 1993 exchange rate crisis when the Belgian franc was vigorously attacked by international speculation.The insufficient alignment of public and monetary policies proved to be at the heart of the financial problems of the 1993 crises. The Belgian government relaunched its policies of budgetary restriction and wage moderation, brought together in what was called the 'Global Plan'. This realignment of public policies to monetary policy swiftly restored the credibility of the Belgian franc, so that as early as January 1994 the Belgian franc converged to its central parity with an interest differential vis-à-vis the German mark of only about 2 %. This differential declined progressively. Indeed the global plan restored the confidence of the investors in Belgian economic policy. Financial markets now fully believed in the entry of Belgium into EMU and from then on no major difficulties were to arise.

Verifiability: A Rationale for the Failure of Intermediate Exchange Rate Regimes

This paper offers a possible theoretical rationale ‐ currently lacking -- for the proposition that intermediate exchange rate regimes are no longer viable. According to this proposition, countries are being pushed to the “corners,” the extremes of either free floating or firm fixing. We introduce the notion of verifiability, by which we mean the ability of a market participant to infer statistically from observed data that the exchange rate regime announced by the authority is in fact in operation. Verifiability is a means to credibility. Our point is that a simple regime may be more verifiable by market participants than a complicated intermediate regime. We study the verifiability of exchange rate regimes by analyzing the case of Chile and by performing Monte Carlo simulations. Simple pegs and basket pegs are relatively easy to verify. As the case of Chile helps illustrate, a band around a peg makes the verification more difficult. Under a narrow band the weights on the central parity can be estimated correctly. However, wider bands make impossible the verification of the central parity. The amount of data that would be required may well exceed the length of the time period during which a given regime is typically maintained. The Monte Carlo exercise shows that the amount of information necessary to verify the exchange rate regimes increases with the complexity of the regime, including the width of the band and the number of currencies in the basket.

A currency crisis model with a misaligned central parity: a stochastic analysis

The currency crisis model outlined in this paper assumes state-contingent reserve dynamics which depend on the deviations of the exchange rate from a misaligned central parity. The size of the misalignment is affected by an underlined fundamental which embodies money aggregates and a stochastic shock. The main result, in the presence of an irreversible switch of regime, is that the size of the attack is amplified by the feedback effect from the composite fundamental to the exchange rate.

Exchange rate target zone models: a Bayesian evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle–Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models. Copyright © 1999 John Wiley & Sons, Ltd.

FX Derivatives with Pre-Announced Peg: EMU Ins

The chosen final convergence for EMU has been to pre-announce the target convergence rate of ERM central parity. This paper analyses some of the pricing and the arbitrage problems market participants had to face between the FX forward and Vanilla option books. We describe a methodology to price FX option when both a peg and the peg level have been pre-announced. We derive explicit pricing formula for FX options and show how--once a parity is announced--the FX dynamics has a stronger link with the interest rates dynamics than in the normal case.

Analysis of Exchange-Rate Target Zones Using a Limited-Dependent Rational-Expectations Model With Jumps

This article examines the exchange-rate determination in a target-zone regime when the bounds can be fixed for an extended period but are subject to occasional jumps. In this case, the behavior of the endogenous variable is affected by the agents' expectations about both the occurrence and the size of the jump. Empirical results using data for the franc/mark exchange rate provide support for the nonlinear model with time-varying realignment probability and indicate that the agents correctly anticipated most of the observed changes in the central parity.

Estimating the fundamental equilibrium exchange rate for the czech economy

When currency turbulences hit the CZK in May 1997, the research presented in this paper had been nearly finished. It tried to contribute to the discussion of sustainability of external development of the Czech economy by comparing signals given by a set of indicators to signals implied by the estimates of fundamental equilibrium exchange rate (FEER) for the CZK.<p> Interestingly, the method of indicators did not give an unambiguous answer. Specifically, when applied to the Czech data, debt as well as solvency indicators did not imply a danger of external crisis. Financial indicators with a shorter-time horizon did send some warning signals. Indicators of competitiveness watched by large international investors considered the CZK to be overvalued since 1995.<p> In order to gain more decisive conclusion concerning the danger of external crisis, the structural approach was employed. The model simulations of the FEER indicated that the CZK became overvalued in 1996 with respect to the central parity of the exchange-rate band. This conclusion was quite robust taking into account behavior of both the real economy as well as decisive external financial flows. The Czech experience with currency turbulences provided an unintentional measure on how good the warning indicators were. The FEER methodology was able to conclude that there was a need for a policy shift in the end of 1996 although it did not give the clear warning that the exchange-rate regime itself was not sustainable.

Exchange Rate Target Zone Models: A Bayesian Evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle-Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models.

Testing for a unit root in ERM exchange rates in the presence of structural breaks: evidence from the bootstrap

This paper explores the extent to which accounting for structural breaks in ERM exchange rates affects inferences on the presence of a unit root in these exchange rates. Four ERM exchange rates, found by previous empirical studies to be nonstationary, are examined. In contrast to previous empirical studies, multiple structural breaks are allowed for to account for multiple realignments in the central parities of these exchange rates. Bootstrapped critical values, personalized to the pattern of breaks of each exchange rate, are used for statistical inference. Consistent with the theoretical conclusion by Froot and Obstfeld (1991), the results suggest that all four ERM exchange rates are stationary. Therefore, accounting for breaks in ERM exchange rates does affect inferences on the presence of a unit root in these exchange rates.

Endogenous Reserves and the Collapse of the Exchange Rate Mechanism: A Stochastic Analysis

This work develops an alternative interpretation of the Exchange Rate Mechanism (ERM) Crises occurred in 1992. The model outlined in the paper assumes that the endogeneity of the reserves with respect to the deviation of the nominal exchange from the central parity exacerbates the size of the speculative attack. By considering a continuous-time stochastic velocity shock in the demand for money equation, it is possible to take into account the feedback effects from the exchange rate to the fundamental in the resulting model with saddle path dynamics. The main result in presence of an irreversible switch of regime is that the size of the attack is amplified. The issue of sustainability of the target zone increases as a time-varying realignment probability is considered in the basic stochastic system.

Optimal stochastic intervention control with application to the exchange rate

We formulate a mathematical model for the optimal control of the exchange rate under uncertainty. The control consists of a combination of: 1. 1. (continuous) stochastic control and 2. 2. an impulse control. We give general sufficient conditions for its solution. The results are applied to the following situation: Suppose that a government has two means of influencing the foreign exchange rate of its own currency: 1. 1. At all times t the government can choose the domestic interest rate t −. 2. 2. At selected times the government can intervene in the foreign exchange market by buying or selling large amounts of foreign currency. We assume that the exchange rate is stochastic and that there are given costs involved in these two actions. It is also costly to have an exchange rate which deviates too much from a given central parity m. How does the government apply its two means of influence in order to keep the exchange rate as stable as possible with minimal expected costs? We formulate this problem mathematically as a combined stochastic control (1) and impulse control (2) problem, and we discuss the solution in a specific example.

The determinants of realignment expectations under the EMS: Some empirical regularities

The stability of the EMS depends crucially on realignment expectations of the market participants. In this paper we discuss how to measure such expectations and how to relate them to economic fundamentals, central bank reputation, and institutional arrangements of the EMS. We find the following empirical regularities for FF/DM and IL/DM exchange rates: 1. (1) expected devaluations are positively related to the current exchange rate deviation from the central parity; 2. (2) expected devaluations are negatively related to the length of time since last realignment in the short and medium run; 3. (3) the Basle-Nyborg agreements seem to have a stabilizing effect for both currencies examined, albeit through different channels.

Deviations from long-run equilibria and probabilities of devaluations: An empirical analysis of Danish realignments

Deviations from Long-Run Equilibria and Probabilities of Devaluations — An Empirical Analysis of Danish Realignments. — The probabilities of realignments between the Danish krone and the D-mark are investigated for the 1979–1995 period. Two multivariate systems are estimated. In the I (1) systems, the deviations from the cointegration relations are used as explanatory variables when determining the probabilities of exchange rate changes. It is found that real imbalances in the economy have to a large extent determined the probabilities of central parity changes. Furthermore, the probabilities of central parity changes have been significantly lower after 1983.

Conditional Volatility of Exchange Rates Under A Target Zone

To study the impact of institutional features of target zones on the conditional volatility of exchange rates, this paper proposes a simple and intuitive model to incorporate the announced information in the bands. Observing the statistical characteristics of the EMS cross rate returns- mean reversion and heteroskedasticity, we t a GARCH(1,1)- MA(1) speci cation incorporating the deviation of exchange rates from the central parity. This model allows us to easily examine the relationship between the conditional volatility and the position of spot rates. We nd in particular, that for the Irish punt and Italian lira DM rates, the conditional volatility increases as the exchange rate approaches the edges of the band. We extend the above univariate model to a multivariate setting to take account of the cross country interactions in the EMS, by including a vector consisting of all EMS currencies' positions in the GARCH equation. The estimation results show that other currencies' positions do a ect the conditional volatility of a speci c EMS currency. Understanding the importance of intra-ERM coherence and the multilateral commitment on the central parity, we follow Pill(1994) to derive an \e ective band model to examine how the multilateral grid affects the conditional volatility. However, the estimation results suggest that the full set of all deviations from ocial central parity of each member country explains the volatility better than does simply the deviation from the effective band.

Devaluations and depreciation expectations in the EMS

This paper proposes a method to estimate separately the size of the expected depreciation in an eventual devaluation of the central parity in the ERM, and the probability assigned by agents to this devaluation occurring in the short run. The proposed method complements the information provided by the jumps observed in market exchange rates around realignments with the information contained in interest rate differentials on the future behaviour of exchange rates. The separation of probability and size allows a richer analysis of the effects of devaluations on exchange rate credibility in the ERM.

The Distribution of Exchange Rates in the EMS

Exchange rates of currencies in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) are characterized by long periods of stability interrupted by periods of extreme volatility. The periods of volatility appear at times of realignments of the central parities and at times when the exchange rate is within the ERM bands. We begin by considering a procedure for finding outliers based on measuring distance as a quadratic form. The evidence suggests that the exchange rates of the EMS can be described by a mixture of two distributions. We therefore model the exchange rate as switching between two distributions—one that holds in stable times and the other that holds in volatile times. In particular, we use Hamilton's Markov-switching model. In addition, we extend Hamilton's model by allowing the probability of switching from one state to another to depend on the position of the exchange rate within its EMS band. This model has the interesting implication that near the edge of the band, large movements—either realignments or large jumps to the centre of the band—are more likely if the move to the edge of the band has been precipitous.

The Distribution of Exchange Rates in the EMS

Exchange rates of currencies in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) are characterized by long periods of stability interrupted by periods of extreme volatility. The periods of volatility appear at times of realignments of the central parities and at times when the exchange rate is within the ERM bands. We begin by considering a procedure for finding outliers based on measuring distance as a quadratic form. The evidence suggests that the exchange rates of the EMS can be described by a mixture of two distributions. We therefore model the exchange rate as switching between two distributions—one that holds in stable times and the other that holds in volatile times. In particular, we use Hamilton's Markov-switching model. In addition, we extend Hamilton's model by allowing the probability of switching from one state to another to depend on the position of the exchange rate within its EMS band. This model has the interesting implication that near the edge of the band, large movements—either realignments or large jumps to the centre of the band—are more likely if the move to the edge of the band has been precipitous.

Divergence indicators and the volatility smoothness in semi-fixed exchange rate regimes

Divergence Indicators and the Volatility Smoothness in Semi-Fixed Exchange Rate Regimes. —Fixed or semi-fixed exchange rate regimes have volatility paths that are in general less smooth than their free floating counterpart. Moreover, there tends to be a correlation between the lack of smoothness and the weakness of the currency. In this article, the effects of divergence from central parity on the smoothness of the volatility are discussed within the framework of a TGARCH model. It is shown that, for various EMS rates, the divergence indicator has a statistically significant effect on the smoothness of the volatility path.