Exchange Market Pressures and Speculative Capital Flows in Selected European Countries


WP/94/21-EA
Exchange Market Pressures and Speculative Capital Flows in Selected
European Countries by Inci Ötker and Ceyla Pazarba o lu


The emergence of intense pressures within the exchange rate mechanism
(ERM) of the European Monetary System (EMS) in late 1992 and 1993 led to the
suspension of two currencies, devaluations of three currencies, and a
substantial widening of the fluctuation bands for most of the currencies of
the ERM. The underlying causes of the recent currency turmoil attracted
significant attention. Some have claimed that while sound economic policies
were necessary, they were not sufficient to prevent speculative runs on
currencies. Others have claimed that the speculative attacks were justified
by the underlying economic fundamentals.

This paper estimates an extended speculative attack model of currency
crises in an attempt to identify the roles of macroeconomic fundamentals
and speculative factors in the recent and earlier currency crises in the
European foreign exchange markets. Three approaches were used to estimate
market expectations of devaluations and to calculate the probability of
a regime change--either a discrete devaluation or a switch to flexible
exchange rates--in a sample of five countries: Denmark, Ireland, and
Spain, which are members of the ERM, and Norway and Sweden, which pegged
their currencies to currency baskets or to the European currency
unit (ECU). The first approach applies the probit technique to the basic
speculative attack model, which calculates the probability of a regime
change as a function of economic fundamentals (level of domestic credit,
real effective exchange rates, foreign interest rates and price level, real
output, unemployment rate, trade balance, and foreign reserves). This
approach was used to evaluate whether a regime change was justified by
economic fundamentals alone. Second, a version of the Bertola and Swensson
(1990) model was used to capture the existence of speculative pressures on
these currencies which operate through interest rate differentials, the
current position of the currency within its fluctuation band, and the level
of foreign reserves. Finally, speculative proxies were combined with
economic fundamentals to evaluate the combined impact of these factors on
the probability of a regime change.

The empirical analysis shows that both economic fundamentals and
speculative factors had a significant influence on the probability of regime
changes for the sample countries. The analysis also confirms that the
latest realignments in the European foreign exchange markets were mainly the
result of foreign exchange market tensions amidst the growing conflict
between the needs of the domestic economies and the policies needed to
maintain fixed exchange rates. Market participants perceived that the
existing parities of the currencies in these five countries were
inconsistent with their underlying economic fundamentals, regardless of the
source of their deterioration, at the time of realignment. Furthermore,
defensive interest rate policies to maintain existing parities have proved
ineffective, as the market perceived such policies to be inherently
unsustainable.