Testing the Credibility of Belgium's Exchange Rate Policy


WP/93/76-EA

Testing the Credibility of Belgium's
Exchange Rate Policy by Ioannis Halikias

The Belgian franc has been a member of the exchange rate mechanism of
the European Monetary System since its inception in 1979. Following
frequent downward realignments of the currency during the first half of the
1980s, Belgium pursued a progressively tighter exchange rate policy, and in
May 1990 the monetary authorities announced their objective to tightly peg
the Belgian franc to the strongest currency within the system.

This paper seeks to determine if long-run exchange rate credibility for
the Belgian franc over the period 1982-92 has been attained. The starting
point of the analysis is the interest rate corridor methodology introduced
by Svensson (1990). This approach assumes that uncovered interest rate
parity holds, and it takes explicit account of the currency's position
within its fluctuation band in testing for exchange rate credibility. Tests
along the lines of the interest rate corridor method suggest that despite
substantial progress, long-run exchange rate credibility for the Belgian
franc can be rejected throughout the period under discussion.

The remainder of the paper explores the sensitivity of this result to
the strong assumption of interest rate parity. In addressing this issue,
the determinants of the Belgian-German long-term interest rate differential
are examined in detail. This differential turns out to be significantly
affected by relative inflation (or relative competitiveness) and by fiscal
variables (both the relative debt-to-GDP ratio and primary deficit-to-GDP
ratio) in the usual ways. In addition, devaluations of the Belgian franc
vis-à-vis the deutsche mark appear to have resulted in a significant
widening of the differential over the short term, while the announcement of
the hard currency policy appears to have led to a narrowing of the
differential. Variables such as the unemployment rate and the external
balance do not appear to significantly affect the differential, suggesting
that the monetary authorities are perceived to attach a relatively low
weight to these objectives.

The paper then breaks down the impact of the fiscal variables into an
exchange rate risk and a sovereign credit risk component, by explicitly
modeling inflationary expectations. The resulting adjustment in the
interest rate corridors reveals that long-run exchange rate credibility
cannot be rejected from mid-1990 onward.