There is a widespread view that the EMS is a `Deutschmark zone', in which Germany determines its monetary policy more or less independently from other EMS members. The other countries peg their currencies to the Deutschmark and, in so doing, subordinate their monetary policies to German policy. Whether the System does work asymmetrically is important to discussions of its evolution: if the EMS's success derives from Germany's dominant role then that role should be prominent in future institutions. In Discussion Paper No. 297, Research Fellow Paul de Grauwe analyses the workings of the EMS in order to determine whether it does operate asymmetrically.
De Grauwe first examines how interest rates react to speculative disturbances. If agents expect, for example, a revaluation of the Deutschmark against the French franc, the forward premium of the Deutschmark will rise. This must lead to an increase in French interest rates or a decline in German rates or some combination of both. The allocation of the burden of adjustment to the speculative shock provides an important indication of the degree of asymmetry. De Grauwe estimates a model in which the monthly change in a country's interest rate is explained by its own past rate, by changes in past and present US interest rates, and the forward premium of the Deutschmark against its own currency. For the German interest rate the equation includes the forward premiums of all EMS currencies against the Deutschmark.
Estimates using monthly data over 1979-88 reveal that in the off-shore markets, speculative shocks have usually forced the interest rates of the weak currencies to increase by the full amount of the expected realignments, leaving the German interest rate unaffected. In countries with capital controls, however, domestic and off-shore rates may diverge significantly during speculative crises. Estimation of the same equations using domestic rates indicates very little asymmetry. The countries of weak currencies, especially those with capital controls, seem to have managed almost completely to insulate their domestic interest rates from speculative crises. Although the elimination of capital controls by 1990 will certainly affect the nature of these interest rate relations, it is too early to tell whether this will make the EMS more or less symmetric, de Grauwe notes.

Evidence that national authorities in EMS countries have been able to insulate their domestic interest rates from speculative disturbances does not mean, however, that their interest rate policies have been determined independently. De Grauwe explores this question by regressing the change in the interest rate of an EMS country on its own past changes and those of the US interest rate. He then tests whether the explanatory power of the equation is improved by adding to it past changes in the interest rate of another EMS country. These `Granger-causality' tests measure how far one EMS interest rate affects another rate, given the US influence on both. In general the results suggest little asymmetry: they indicate two-way interdependence for a number of short-term domestic interest rates, and no interdependence for most long-term rates.
The EMS may work more symmetrically than is commonly assumed, de Grauwe concludes, and its success may have relatively little to do with German leadership. These findings have implications for the future shape of EMS institutions. Although it may be desirable that one country takes a leadership position in future EMS institutions, the argument for such an asymmetry should not be based on the present workings of the System

Is the European Monetary System a DM-Zone?
Paul de Grauwe

Discussion Paper No. 297, March 1989 (IM)