Expected Devaluation and Economic Fundamentals


WP/93/83-EA

Expected Devaluation and Economic Fundamentals by Alun H. Thomas

The two episodes of exchange rate collapse within the exchange rate
mechanism (ERM) of the European Monetary System in September 1992 and August
1993 have kindled tremendous interest in understanding the causes of such
forced parity changes. After a period of five years with fixed central
parities, pressure built up during the summer of 1992 against the pound and
lira which led to the suspension of both currencies from the ERM. At the
beginning of August 1993, a communiqué was issued announcing the widening
of the obligatory marginal intervention thresholds of the remaining
participants in the ERM to +15 percent around each central parity.
This paper addresses the question of whether--and if so, how--these
episodes of exchange market pressure are related to economic fundamentals
by considering the examples of France and Italy. It demonstrates that the
interest rate differential corrected for expected depreciation within the
band is a reasonable estimate of expected devaluation for France, Italy,
and the United Kingdom. The estimate of expected devaluation for the French
franc, unlike the estimate for the Italian lira, can partly be explained by
variables which reflect external and internal imbalances. In the analysis,
the dominant explanatory variable is the position of each currency in its
target band, and this variable is only weakly related to standard macro-
economic fundamentals. When the band position variable is excluded from
the analysis, official holdings of foreign exchange reserves become a
significant determinant. However, the effect of the standard macroeconomic
fundamentals is weak because no variable provides significant explanatory
power for France and Italy over the whole period, and only the unemployment
rate provides significant explanatory power for Italy for the subperiod
1987-92.