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FABSF

WEEKLY LETTER

Number 93-18, May 7, 1993

European Exchange Rate Credibility
before the Fall: The Case of Sterling
In September 1992 the European Monetary System faced a currency crisis. The eleven countries
participating in the Exchange Rate Mechanism
(ERM), which involves maintaining cross-rate
pegs to each others' currencies, experienced a
series of speculative attacks on their currencies.
Within a single week, these attacks forced two
devaluations and, more importantly, forced the
Italian lira and the British pound sterling to drop
out of the ERM altogether; these two currencies
have been floating since then.
Most onlookers agree that the ultimate source
of the crisis was macroeconomic in nature. It
stemmed from the high fiscal cost of German
unification combined with the unwillingness of
Germany's central bank to ease monetary policy
in order to accommodate this expansionary fiscal
policy (see the Weekly Letter of October 16,
1992). The immediate causes of the currency
crisis, however, are not as clear. It is sometimes
asserted that the underlying macroeconomic
problems led speculators to doubt the credibility
of European monetary authorities--that is, as the
size of the underlying problems became apparent, credibility slowly diminished, a process that
culminated in the currency crisis.
In this Letter, I investigate whether private financial market participants anticipated the currency
crisis, and therefore doubted the credibility of
the ERM, long before the system was actually attacked. I define a highly credible fixed exchange
rate as one which the financial markets do not
expect to change and an exchange rate with low
credibility as one which the financial markets expect to be devalued. More precisely, I estimate
and interpret quantitative measures of the credibilityof European exchange rates, focusing on
the period before "Black Wednesday," September
16, 1992, when the pound and the lira were
forced to drop out of the ERM. I place particular
emphasis on the case of the British pound during
1992. The pound is an intrinsically interesting
case, since the British government, which has
more direct control of monetary policy than most

other ERM members, was highly committed to
maintaining the pound within the ERM.
The expectation of a sterling realignment is estimated using the "drift adjustment" technique,
described in Rose and Svensson (199,2). This
technique distinguishes the "normal" movement
of a currency around its peg from the more pronounced interest rate movements that would
signal the expectation of realignment. Thus, the
measures estimated reflect the private financial
markets' assessment of the credibility of fixed
exchange rate regimes.
The chief finding is that sterling's peg appeared
to be credible throughout much of 1992. Indications that the market expected a realignment
did not become really significant until September
1992, immediately before the crisis. Thus, there
is no evidence that British and Italian policymakers reacted tardily to a situation that was clearly
seen by financial markets as critical; rather, both
policymakers and the financial markets were
taken by surprise. This conclusion holds for the
other currencies in the ERM as well.

Interest differentials
and exchange rate expectations
As a member of the ERM, the UK committed
itself to keeping its exchange rate vis-a-vis
Germany, as well as the other members, close
to "central parity" rates chosen when the UK
entered the ERM in 1990. The first signs of
a breakdown in that commitment, that is, of a
realignment of the pound, would have appeared
in the difference between interest rates in the
UK and in Germany. If British interest rates were
higher than German interest rates for comparable
securities, investors would expect a depreciation
of sterling vis-a-vis the OM; otherwise the return
on British and German assets would differ and
investors would not hold both securities. Thus,
the interest rate differential is a measure of the
expected rate of change of the exchange rate,
and it is the first place to look for indications of
an expected sterling real ignment.

FRBSF
Figure 1 plots the difference between British
and German interest rates for three-month Eurosecurities from steriing'sERM entry in October
1990 through the end of October 1992. The vertical line marks BlackWednesday, the day sterling
dropped out of theERM. Clearly, interest rate differentials fell virtually continually after the UK
joined the ERM. They rose only briefly in midSeptember 1992, and even then only to modest
levels (both compared with the previous few
years and with other ERM participants). Thus,
the raw data on interest differentials give little
evidence that financial markets expected a sterling realignment until immediately before Black
Wednesday. Interest rate differentials with both
longer and shorter maturities yield the same
conclusion.

Figure 1
Daily U.K.-German

Interes~

Rate Differentials
Percent

6.0

September

1992

4.0
2.0

-----------"-"'-'---t"1+

0.0
-2.0

rr-rTirn--rT-rT""T""'T"'T""T"'T""T""-"""-ro-1M-+

Oct

Jan

Apr

Jul

1991

Oct

Jan

Apr

Jul

-4.0

toward the middle again, that is, to depreciate
somewhat. This expected depreciation within the
band could fully, or more than fully/account for
the total expected depreciation manifest in the
interest differential. This suggests that interest
rate differentials (the expected total exchange
rate change) should be adjusted to take into account expected exchange rate drift within the
band (using the "drift adjustment" technique) in
order to yield a measure of realignment expectation5 (expectations of a change in the central
parity). If this measure is high, then the exchange
rate central parity is expected to be devalued,
that is, the exchange rate peg is not credible.
Clearly, higher realignment expectations are associated with expectation of a bigger or faster
realignment (or both). Conversely, a negative
value indicates expectations of a sterling revaluation (against the Deutschemark).
Figure 2 graphs expectations of a sterling realignment, that is, the interest differential after
adjusting for expected daily exchange rate drift
within the band. The graph plots an expected
realignment of 5 percent (a reasonable guess,
given the traditional size of ERM realignments)
calculated using data over the period of sterling's
participation in the ERM, October 1990 through
September 1992. The vertical axis indicates the
expected timing of the realignment times its expected size. Therefore, to find the probability
of a 5 percent realignment in the next month,
divide the measure by 12; for example, In October 1990, the measure was 2, and 2/12 equals
about a 17 percent probability of a 5 percent
realignment. Adjusting interest differentials for
expected exchange rate drift clearly leads to a
more volatile and accurate measure of realignment expectations. (Again different maturities
yield similar information.)

Oct

1992

Figure 2
Expectations of a 5% Sterling Realignment

Adjusting for Exchange Rate Drift
The Briti5h-German interest rate differential
remained low and positive throughout most of
1992; that is, the pound was expected to depreciate, but only by a small amount. However, this
does not mean that the market viewed realignment as being unlikely. Sterling was a "wideband" participant in the ERM; that is, its bilateral
DM rate could move by as much as 6 percent
around the central parity. But up until Black
Wednesday, it also tended to drift back to the
middle of the band fairly quickly after it had
been pushed to the edge. This behavior was common for the other ERM currencies as well. So, for
example, if sterling had appreciated to the strong
edge of the band, it was expected to drift back

Oct

Jan

Apr

Jul

1991

Oct

Jan

Apr

Jul

1992

Oct

The derived series seems sensible; realignment
expectations were low right after sterling's ERM
entry but rose during the uncertainty surrounding the Conservative leadership conference of
November 1990 when Margaret Thatcher was
ousted as Prime Minister. Realignment expectations then fell following John Major's victory
(which is not surprising, since he was instrumental in bringing the pound into the ERM), and remained relatively low until the 1992 general
election. After the Conservative victory in the
general election of April 1992, realignment expectations fell off dramatically. The most important message is that realignment expectations
were quite low during the immediate run-up
to August 1992. Realignment expectations in
mid-August 1992 were comparable to those
before the general election of April. Indeed, the
negative values during the early part of the summer of 1992 indicate that insofar as the market
expected any realignment, it was for a sterling
revaluation.

Figure 3
Expectations of a 5% Lira Realignment

2.0
0.0

-2.0
,--,---..,--.,---,----r---+ -4.0
1987

1988

1989

1990

1991

1992

Figure 4
Expectations of a 5% Franc Realignment

Just as with realignment expectations for the
UK, the realignment measures for the other two
countries rose dramatically in the late summer of
1992. There were few serious expectations of a
European currency crisis until mid-August 1992
at the earliest (with the possible exception of the
lira). Perhaps even more interesting is the fact that
realignment expectations, even in the late summer of 1992,were comparable to those experienced by ERM participants during the previous
five years of exchange rate tranquility. Thus,
there is little evidence from financial data that
the ERM in the late summer of 1992 was in a
period without historical precedent. Rather, most.
interest and exchange rate data indicated "business as usual."

2.0
0.0

-2.0
-4.0
1987

1988

1989

1990

1991

1992

expected drift of exchange rates within ERM
bands. Two substantive points emerged. First,
expectations of a sterling realignment were low
throughout most of (1991 and) 1992, both absolutely and relative to other ERM currencies.
Sterling's credibility was not in reasonable doubt
until mid-August 1992, at the earliest. Second,
the ERM (including sterling) had previously
weathered crises of the magnitude that markets
had expected even through early September
1992. In light of this evidence, it is hard to blame
European policymakers for reacting slowly to a
situation of growing tension, since there were
remarkably few indications of a brewing crisis.

Andrew K. Rose
Associate Professor, U.c. Berkeley
Visiting Scholar, FRBSF

Summary
This Letter has used daily data to measure the
expectations of financial markets concerning
future ERM realignments. The empirical technique adjusted interest rate differentials by the

6.0
4.0

Evidence for other ERM participants
Figures 3 and 4 contain data on expectations of a
5 percent realignment for Italy and France since
January 1987, the date of the last serious ERM
realignment before 1992. Italy was forced out
of the ERM on Black Wednesday; while France
has not devalued since 1987, its currency was attacked (and successfully defended) in September
1992; the case of France is similar to most of the
other ERM members.

6.0

Reference
Rose, Andrew K., and Lars E.G. Svensson. 1992.
"Expected and Predicted Realignments." Mimeo.
U.c. Berkeley.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

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Index to Recent Issues of FRBSF Weekly Letter

AUTHOR

DATE NUMBER TiTlE
11/13
11/20
11/27
12/4
12/11
12/25
1/1
1/8
1/22
1129
2/5
2/12
2/19
2/26
3/5
3112

3/19
3/26
4/2
4/9
4/16
4123
4/30

92-40
92-41
92-42
92-43
92-44
92-45
93-01
93-02
93-03
93-04
93-05
93-06
93-07
93-08
93-09
93-10
93-11
93-12
93-13
93-14
93-15
93-16
93-17

u.s.

NAFTA and
Banking
A Note of Caution on Early Bank Closure
Where's the Recovery?
Diamonds and Water: A Paradox Revisited
Sluggish Money Growth: japan's Recent Experience
Labor Market Structure and Monetary Policy
An Alternative Strategy for Monetary Policy
The Recession, the Recovery, and the Productivity Slowdown
Banking Turnaround
Competitive Forces and Profit Persistence in Banking
The Sources of the Growth Slowdown
GDP Fluctuations: Permanent or Temporary?
The Twelfth District Agricultural Outlook
Saving-Investment Linkages in the Pacific Basin
A Single Market for Europe?
Risks in the Swaps Market
On the Changing Composition of Bank Portfolios
Interest Rate Spreads as Indicators for Monetary Policy
The Lonesome Twin
Why Has Employment Grown So Slowly?
Interpreting the Term Structure of Interest Rates
California Banking Problems
Is Banking on the Brink? Another Look

u.s.

Laderman/Moreno
Levonian
Cromwell/Trenholme
Schmidt
Moreno/Kim
Huh
Motley/judd
Cogley
Zimmerman
Levonian
Motley
Moreno
Dean
Kim
Glick/Hutchison
Laderman
Neuberger
Huh
Throop
Trehan
Cogley
Zimmerman
Levonian

The FRBSF Weekly Letter appears on an abbreviated schedule in june, July, August, and December.