Exchange Rate Mechanism Research Articles

Public debt improves the stability of exchange rates in developing countries? The specific case of news European members (2004 and 2007)

The aim of this paper is to speak about the current situation in Central and Eastern European countries (CEEC). The majority of them have been entering in European Union in 2004 and 2007. This step has been increasing their international attractiveness and improves their economic growth. However, they must stabilize exchange rate to sustain their foreign direct investment attraction. Two strategies are adopting about the regulation of exchange rate. Bulgarian, Estonia, Latvia, Lithuania Slovenia and Slovakia are entering in Exchange Rate Mechanism 2 (ERM2) to adopt quickly euro currency (it is now the case for Slovenia in 2007, Slovakia in 2009 and Estonia in 2011). Hungary, Poland, Czech Republic and Romania prefer only to stabilize their currency for the moment. Despite the strong economic dynamic of these countries before the Subprime crisis, the impact reveals the incapacity for several of them to improve currencies stabilities. The theoretical approach about Mundell-Fleming trilemma informs the necessity to scarify monetary policy in a context of free financial market and fixed exchange rate. In a reality, the capacity to use fiscal policy appears supplementary indeed more efficient.

The Sovereign Debt Crisis in Europe, Save Banks Not States

Abstract The European central bank is a bank of banks but not a bank of states. This reduces the capabilities of member states to finance deficits. The role of the central bank to cope with the debt crises is institutionally more limited than in most other Western countries. The European Stability Mechanism has not enough financial power to bail out all distressed countries in the Eurozone. Eurobonds could increase lending capacities but would require a change of the European treaty, which is not in sight. They violate the no bail out clause of Art.125 of the Treaty on the Functioning of the European Union. The policy option is therefore debt restructuring of distressed countries and a bailout of financial institutions to avoid conflagration. This option would also shift some of the burden to creditors outside the Eurozone rather than to shift all risk on the people in solvent countries within the Eurozone. JEL classification: G01, K33 Keywords: Euro, European debt crisis, European Central Bank, European Stability Mechanism, Debt restructuring, Sovereign insolvency, no bail out clause, Eurobonds 1. Why the Euro? What is the economic rationale for the Euro? Some economists, Paul Krugman the most prominent among them, maintain that there is no rationale at all and view the Euro as a purely political and even romantic project for a disparate economic zone for which a single currency fits like the saddle on the cow2. If they are right, the Euro cannot and should not survive and hence the best strategy to end the current crisis would be to reintroduce national currencies. This would allow troubled countries to devaluate their currencies and thus regain international competitiveness. However others, including Barry Eichengreen, one of the most knowledgeable observers of the European Union and its financial architecture think differently. In his article in the Journal of Economic Literature Eichengreen maintains that the introduction of the Euro was a consequent move after the establishment of the single European market. The European Union is not just a customs union but also a free market for services, capital and labor. The European treaties, the large body of secondary law and the decisions of the European Court of Justice have removed even the most remote barriers to the entry of national markets. No other collection of states has achieved this depth of market integration. The downside of this is an inherent vulnerability to sudden exchange rate changes in member countries, which can have major disruptive effects. This consequence of the single European market led to the introduction of the European exchange rate mechanism with almost fixed exchange rates as early as 1979. But with different inflation rates within the EU this mechanism was unstable. In 1992 both Britain and Italy heavily devaluated their currencies. This led to disruptions in the industries of other member states with huge layoffs of workers and a devaluation of the capital stock in export as well as import substituting industries. The consequence of this experience was the decision to take the risk of a common currency, in which such disruptions for investors and workers cannot occur3. Without the Euro it is questionable whether the deep market integration is sustainable. It might have to give way to a form of integration closer to what we have in the GATT/WTO framework. Just to illustrate: In Greece a newly appointed schoolteacher with a University degree currently earns a salary of little less than 1000 Euro per month and 80 per cent of employees in the public sector earn between 1000 and 15000 euros4. Assume that Greece would reintroduce the Drachma and devaluate it by 50 per cent as analysts forecast for that scenario. The salary would then decline to less than 500 Euro per month. This might lead to massive emigration like in neighboring countries Bulgaria and Romania, or in Poland, which are EU member states but not part of the Euro zone. …

Inflation Targeting in Romania in the Perspective of Joining the Exchange Rate Mechanism II

Since the early 1990, when the Reserve Bank of New Zeeland instituted for the first time inflation targeting (IT) as its monetary policy framework, IT gained reputation, becoming the monetary regime of choice of many central banks around the world. Among them, the National Bank or Romania changed in mid-2005 the strategy of the monetary policy with IT. As a member of the European Union, Romania’s ultimately aspiration is the adoption of the euro as a means to achieve its objective of full participation in the European Monetary Union. In order to accomplish that, among other nominal and real convergence criteria, Romania must spend at least two years in the ERM II, keeping its exchange rate towards the euro stable, inside a band of ±15%.The purpose of this paper is to identify the challenges of direct IT implementation in Romania in the current context with the perspective of joining the ERM II. We will find out that IT, as current monetary policy strategy, is to be maintained at least until the ERM II entry. After that the NBR’s focus will shift back from price stability to exchange rate stability, and thus, a strict IT framework will not be appropriate anymore (the co-existence of IT with an explicit exchange rate objective being quite problematic). The paper concludes that a soft version of inflation-targeting is more appropriate under the given circumstances.

EQUILIBRIUM REAL EXCHANGE RATES

This paper analyzes the role of the real exchange rate in macroeconomic equilibrium. The supply-side equilibrium exchange rate, that level of the real exchange rate at which (relative) inflation is constant, is derived from a simple macro-model and related to the standard NAIRU model. The stabilizing role of monetary policy in adjustment towards the supply-side equilibrium exchange rate is analyzed both before and after entry to the exchange rate mechanism of the European Monetar System. Resolution of the conflict between supply-side and external equilibrium produces a stricter definition of the fundamental equilibrium exchange rate of J. Williamson. Copyright 1992 by Blackwell Publishers Ltd and The Victoria University of Manchester

FINANCIAL FRICTIONS AND THE CHOICE OF EXCHANGE RATE REGIMES

This article provides a quantitative assessment of the role of financial frictions in the choice of exchange rate regimes. I use a two‐country model with sticky prices to compare different exchange rate arrangements. I simulate the model without and with borrowing constraints on investment, under monetary policy and technology shocks. I find that the stabilization properties of floating exchange rate regimes in face of foreign shocks are enhanced relative to fixed exchange rate in presence of credit frictions. In presence of symmetric and correlated shock, fixed exchange rates regimes can perform better than floating. This analysis can have important policy implications for accession countries joining the European Exchange Rate Mechanism II system and with high degrees of credit frictions. (JEL E3, E42, E44, E52, F41)

The Euro and the Volatility of Exchange Rates

This paper attempts to determine whether or not the introduction of the euro affected the volatility of bilateral exchange rates all over the world. To that end, we examine the exchange rate behaviour for a set of OECD and non-OECD countries during the 1993-2007 period. Two econometric methods are implemented for this purpose: the OLSbased tests to detect multiple structural breaks, as proposed by Bai and Perron (1998, 2003), and several procedures based on Information Criterion together with the so-called sequential procedure suggested by Bai and Perron (2003). Although results suggest evidence of structural breaks in volatility across investigated variables, there is high heterogeneity regarding the located dates. Moreover, the realignments in the Exchange Rate Mechanism seem to play a significant role in the reduction of volatility in some European countries and transition economies.

A Markov switching analysis of contagion in the EMS

This paper applies the multivariate version of the Forbes and Rigobon (2002) contagion test, as proposed by Dungey et al. (2005a), to detect contagion effects in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). Crisis and non-crisis observations are determined endogenously via a Markov-switching vector autoregression (MSVAR). We show that the MSVAR is suitable for this purpose, as it does particularly well in identifying the 11 realignments of the ERM. We examine whether Denmark’s rejection of the Maastricht Treaty and Italy’s competitiveness problems affected other EMS participants and find evidence for contagion.

MONETARY POLICY COOPERATION TO SUPPORT ASIAN ECONOMIC INTEGRATION

This paper considers the form of monetary policy coordination and regional exchange rate arrangement that would best support economic and financial integration in East Asia. In view of the region's economic diversity, we propose a graduated program of informal policy cooperation from weak forms of cooperation to more intensive modes of cooperation such as the adoption of common monetary policy objectives. An array of informal monetary arrangements rooted to the degree of institutional development can improve the effectiveness of both sovereign and regional institutions, and promote integration in East Asia. Drawing upon the European experience with the Exchange Rate Mechanism (ERM), we conclude that East Asia should first embark on other forms of integration to aid in the development of a high degree of real and nominal convergence amongst the regional countries. Only then would an ERM-type system that employs a regional monetary unit become more sustainable and less susceptible to speculative currency attacks in the region.

Exchange rate and interest rate distribution and volatility under the Portuguese target zone

The aim of this study is to analyse the exchange rate and interest rate distribution and volatility under the participation of the Portuguese economy in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) based on some of the main predictions of the target zone literature. Portugal adopted this exchange rate target zone from April 6 1992 until December 31 1998. During this period, the exchange rate distribution reveals that the majority of the observations lie close to the central parity, thus rejecting one of the key predictions of the Paul Krugman (1991) model. The analysis of the data also shows that exchange rate volatility tended to increase as the exchange rate approached the edges of the band, contrary to the predictions of the basic model. Interest rate differential volatility, on the other hand, seemed to behave in line with theoretical predictions. This suggests an increase in the credibility of monetary policy, allowing us to conclude that the adoption of a target zone has contributed decisively to the creation of the macroeconomic stability conditions necessary for the participation in the European Monetary Union (EMU). The Portuguese integration process should therefore be considered as an example to be followed by other small open economies in transition to the euro area.

As relações de troca em região de fronteira: uma proposta metodológica sob a ótica convencionalista

The studies about the economical, social and cultural reality of the outlying border zones are constituted in challenges of difficult articulation and consensus. For the economical coordination analysis, the exchange rate mechanism becomes insufficient - if it is treated as the only mean of coordination – faced with the plurality of articulation and interaction processes that involve the characters, the territories and the institutions culturally distinguished. This theoretical contextualization of the economic conventions is revealed in a significant instrument to treat aspects involving the degree of trust, reciprocity, the tacit approvals and the value judgments in a clear approach among the economical, social and political sciences. The objective of the present work is proposing a theoretical reflection based on the conventional approach on the characters coordination mechanisms of different border territories.

The Prospect of Euro Adoption in Romania

Taking into account the schedule of Romania’s monetary integration: the entrance into Exchange Rate Mechanism II in 2012 and the euro adoption in 2014, our authorities have become preoccupied in accelerating the convergence process. This paper aims to analyze Romania’s progress in the convergence process, as well as, the current stage of the fulfilment of nominal and real convergence criteria required for euro adoption. In the same time we compare the results obtained by our country and those recorded in other Central and Eastern European states in the integration process. We also debate on the main reasons responsible for delaying the convergence process in Romania and the prospect of speeding up this process without a negative impact on the economy.

Can the European Monetary System be a model for East Asian monetary cooperation?

Since the 1997 Asian financial crisis and the launch of the European Economic and Monetary Union shortly afterward, a growing number of studies have considered the idea of a so-called Asian Monetary System, mostly adopting the European Monetary System as its model. The operational adjustment burdens in the European Monetary System were asymmetrically distributed, however, in particular between Germany and the other member countries. The emulation of such an asymmetric system in East Asia is not likely to be sustainable, due to the much lower support for regional integration there than was the case in Europe. For a future Asian Monetary System to be sustainable, it should be designed in such a way as to promote symmetry in the adjustment burdens arising from its operation. To this end, it may be desirable for the Asian Monetary System to employ an exchange rate and intervention mechanism that levies adjustment burdens largely on participant currencies deviating substantially from the average member currency movements. This mechanism should also be constructed in such a way that each currency's probability of identification as a deviant currency is similar.

Institutional Arrangements of Currency Boards - Comparative Macroeconomic Analysis

This paper is concentrated on the comparative macroeconomic analysis of the differences stemming from the extent to which the institutional framework of the currency board arrangement is implemented in the legal and regulatory systems in the different countries. The main objective of taking into consideration and examining the currency board institutional arrangements is to distinguish between the impact that currency board countries and countries with pegged exchange rate have on different macroeconomic indicators. During the analysis of these two extreme representatives of the fixed exchange rate mechanism, a third group of countries naturally emerges, which consists of countries acting like currency boards but without official, legal implementation of this arrangement. Once the distinction among all 22 countries taken into consideration had been made, the main scope of the analysis concentrates on the econometric estimation of the currency boards' effects over inflation, nominal and real interest rates and economic growth in countries under currency board and all other pegged exchange rate economies. The main hypothesis to be tested is whether the implementation of currency board arrangement results in lower inflation, lower nominal and real interest rates and better economic growth. In the course of carrying out a thorough empirical research, the hypothesis turns out to be true as the currency board countries exhibit almost 3% lower annual inflation differential when putting them against the other pegged exchange rate systems, and 1% point advantage over the countries similar to currency boards. On average, countries with currency boards showed higher economic growth, fact that can be even surprising taking into consideration the inabilities of the monetary authorities to intervene heavily on the market and neutralise the negative effects of various external shocks.

The Forex Forward Puzzle: The Career Risk Hypothesis

We conjecture that the forward puzzle may reflect career risks. When professional investors observe public danger signals about a currency, they require a premium for holding it. We find evidence of this in Exchange Rate Mechanism rates. As deep discounts do signal danger, we next specify nonlinear variants of the Fama regression to capture this risk. We also decompose the forward premium into a long-memory trend and short-term component. We find empirical evidence for a career risk premium; risk is in fact dominant in the trend component while the short-term component loads more on expectations. All confidence intervals are calculated via Monte Carlo.

The Forex Forward Puzzle: The Career Risk Hypothesis

AbstractWe conjecture that the forward puzzle may reflect career risks. When professional investors observe public danger signals about a currency, they require a premium for holding it. We find evidence of this in Exchange Rate Mechanism rates. As deep discounts do signal danger, we next specify nonlinear variants of the Fama regression to capture this risk. We also decompose the forward premium into a long‐memory trend and short‐term component. We find empirical evidence for a career risk premium; risk is in fact dominant in the trend component while the short‐term component loads more on expectations. All confidence intervals are calculated via Monte Carlo.

Challenges for the new EU member states on the road to the Eurozone

This paper analyses the process of nominal and real convergence in the new Member States of the European Union (NMS). The importance of nominal and real convergence is underlined in connection with a successful catching-up. The NMS economies experienced robust economic growth in recent years, which had a positive impact on the convergence process. Although this favourable development of real convergence is accompanied by a simultaneous price (nominal) convergence, the comparative price level is still biased towards lower level in comparison with the per capita income. The regression analysis shows interdependence between the comparative price and the income per capita level. This basis enables to evaluate potential benefits and risks connected with joining the euro. The benefits connected with elimination of exchange rate risks and reduction of transaction costs can be compared with the disadvantages associated with the loss of an independent monetary policy and an adjusting exchange rate mechanism. Attention is paid to a potential impact on nominal and real convergence of the observed countries. There are some risks for these countries connected with the common monetary policy, which is adjusted more to the conditions of stabilized advanced economies, forming the core of the Eurozone. These risks can be overcome on the basis of a fast labour productivity growth, accompanied by an adequate policy, ensuring the macroeconomic stability. The rapid productivity growth is raising the relative price level. The Maastricht dilemma, i.e. the fulfilment of two objectives during the stay in ERM II (the price stability and the exchange rate volatility) under on-going nominal convergence enforces an appropriate monetary and fiscal policy. However, such strict policies may slow down the economic growth. Another possible measure for keeping the price stability is a relaxation of the fluctuation band (its full exploitation to the upper and bottom limits), or a change of the central parity (revaluation).

A heterogeneous route to the European monetary system crisis

We estimate a dynamic heterogeneous agents model for the British pound during the European monetary system crisis. We illustrate the chain of events leading to the suspension of the pound from the exchange rate mechanism in terms of switching beliefs, from fundamentalist to chartist.

Real-Time Effects of Central Bank Interventions in the Euro Market

This paper investigates the real-time effects of foreign exchange intervention using official intraday intervention data provided by the Danish central bank. Denmark is currently pursuing an active intervention policy under the provisions of the Exchange Rate Mechanism (ERM II) and intervenes on a discretionary basis when considered necessary. Prior participation in ERM II is a requirement for adoption of the Euro. Therefore, our study is of particular relevance for the new European Union member states that are either currently participating in ERM II or expected to do so at a later date as well as for Denmark. Our analysis employs the two-step weighted least squares estimation procedure of Andersen, Bollerslev, Diebold and Vega (2003) and an array of robustness tests. We find that intervention exerts a statistically and economically significant influence on exchange rate returns when the direction of intervention is consistent with fundamentals and intervention is carried out during a period of high exchange rate volatility. We also show that the exchange rate does not adjust instantaneously to the unannounced and discretionary interventions under study. We conclude that intervention can be an important short-term policy instrument for exchange rate management.

Commercial banking, insurance and economic growth in Sweden between 1830 and 1998

We examine empirically the dynamic historical relation between commercial bank lending, insurance and economic (income) growth in Sweden using time-series data from 1830 to 1998 and performing tests for Granger causality. Because of the non-stationary nature of the time series examined the procedure of Toda and Yamamoto (1995) is used. Our results, which have accounted for possible regime changes due to different exchange rate mechanisms over time, indicate that insurance has Granger-caused economic growth and bank lending. Therefore, we conclude that insurance is an important prerequisite for stimulating economic growth and that this could have important implications for contemporary developing economies

Exchange Rate Behaviour of East European Transitional Economies

Eastern European countries, which are candidates for accord into the Exchange Rate Mechanism (ERM) and the eventual move towards Euro, fi nd exchange rate management a tedious challenge. This paper examines the underlying factors that move exchange rates and helps us to contribute towards streamlining policies and strategies in moving these countries forward. The new findings on exchange rate determinants for this group of transitional economies are based on parity factors as well as non-parity factor effects. The evidence that emerges from this paper is that non-parity factors including economic growth rate, current account and capital flows are significantly correlated with exchange rates. The results are robust whichever data set is used, high-frequency and low-frequency data sets.