While the dependence of fixed exchange rate systems on market participants' realignment expectations is well understood, much less is known about the determination of those expectations. In Discussion Paper No. 790, Zhaohui Chen and Programme Director Alberto Giovannini assume interest rate parity and thereby measure expected devaluations in terms of expected changes to deviations from the central parity. In an empirical investigation of realignment expectations for the French franc/Deutschmark and lira/Deutschmark exchange rates under the EMS, they use the period since the last realignment as a proxy for the public's subjective probability of devaluation in face of an adverse shock, whose strength is measured in terms of `fundamental' variables. They then assess the effectiveness of the EMS in reducing realignment expectations in terms of deviations from the central parity, institutional coordination to counteract crises and speculation, and reactions of foreign exchange markets.

Chen and Giovannini find that most macroeconomic fundamentals exert the expected effects on realignment expectations. These decline as the country's position improves relative to the anchor currency country and are related positively to deviations from the central parity and negatively to the length of time since the last realignment. These results imply that the target zone is not an adequate stabilizer of realignment expectations and that a tougher policy stance by the central bank may help to establish reputation. Chen and Giovannini also show that the Basel-Nyborg agreement reduced realignment expectations in France and Italy (through different channels). The observed tendencies for large revaluation expectations to follow devaluations and realignment expectations to increase with deviations from central parities suggest that markets use information inefficiently after realignments, which may reflect over-speculation or `herd' behaviour.

The Determinants of Realignment Expectations Under the EMS Some Empirical Regularities
Zhaohui Chen and Alberto Giovannini

Discussion Paper No. 790, June 1993 (IM)