Shorter Papers Testing the Credibility of Belgium's Exchange Rate Policy

IMF SkJjf Papm Vol. 41, No. 2 (June 1994) C 1994 International Monetary Fund

Shorter Papers

Testing the Credibility of Belgium's Exchange Rate Policy

IOANNIS HALIKIAS*

This paper examines the credibility of the exchange rate policy pursued by the Belgian monetary authorities of pegging the Belgian franc to a narrow fluctuation band around the deutsche mark, in the context of the exchange rate mechanism of the European Monetary System. Simple interest rate corridor analysis, based on the Belgian-German long-term interest rate differentiai and taking explicit account of the currency's position within its fluctuation band, appears to suggest that the hypothesis that long-run exchange rate credibility has been attained should be rejected, even though considerable progress has been made in this regard since the early 1980s. The paper proceeds to decompose the Belgian-German interest rate differ entia/ into a sovereign credit risk and an exchange rate risk component, by modeling inflationary expectations, and concludes that long-run exchange rate credibility cannot be rejectedfrom 1990 onward. [JEL E43, F31, F33]

HIS PAPER ADDRESSES the question of the credibility of Belgium's Texchange rate policy within the European Monetary System (EMS) over a period ranging from the early 1980s almost until the widening of the EMS fluctuation bands in August 1993. During this period, the general trends of the Belgian franc (BF) exchange rate have varied significantly. Over the first half of the period, devaluations vis-à-vis the deutsche mark (DM), either unilateral (as in February 1982) or as part of general EMS realignments, were frequent. Since January 1987, the BF/DM central parity bas remained unchanged.

• Ioannis Halikias, an Economist in the European 1 Department, holds an M.Phil. in economies from Yale University. The author thanks Francesco Caramazza, Paul Masson, and Hari Vittas for helpful comments and Susan Becker for research assistance.

350

©International Monetary Fund. Not for Redistribution THE CREDIBILITY OF BELGIUM'S EXCHANGE RATE POLICY 351

Belgium bas been a member of the exchange rate mechanism (ERM) of the EMS since its inception in 1979, with the BF placed in the nar row ± 2.25 percent fluctuation band. Since May 1990, Belgium's ex change rate policy stance bas hardened further, as the monetary author ities announced that the BF would closely track the strongest EMS currency (''franc fort" policy). Since theo, and untii the widening of the EMS bands from 2.25 percent to 15 percent in August 1993, BF fluctu ations vis-à-vis the DM have been negligible, generally limited to a ± 0.5 percent range (Figure 1). Given Belgium's status as a small, open economy, exchange rate policy constitutes an important element of its anti-inflation strategy. Economies such as Belgium are often viewed as suffering from a credibil ity problem of the type analyzed by Barro and Gordon (1983). In partic ular, it can be argued that, if an in dependent monetary po licy is pursued, it is difficult to adhere to a time-consistent policy rule. Under these conditions, the rational expectations equilibrium involves a rate of infla tion that is higher than the social optimum. Giavazzi and Pagano (1988) argue that such countries can overcome this problem by giving up mon etary independence and pegging their currencies to a currency such as the DM, effectively "borrowing" the Bundesbank's anti-inflation reputa tion. The argument assumes that the costs of reneging on such a policy are prohibitively high. lnterest rate differentiais are an indicator traditionaliy employed to assess exchange rate credibility. Figure 2 depicts the trends in the long- and short-term Belgian-German interest rate differentiais during 1982-92. The figure provides strong prima facie evidence that Belgium bas made progress in strengthening the credibility of its exchange rate policy over this period. The long-term differentiai declined from about 5 percent in 1982 to about 0.7 percent in 1992, whereas the short term differentiai, which stood at almost 5 percent in 1982, practically disappeared. Suggestive as the trends in Figure 2 may be, they fail to provide a conclusive test of exchange rate credibility. In general, the use of in terest rate differentiais as a credibility indicator in the context of a target zone setting suffers from two limitations: on the one band, it faiis to consider the currency's position within its fluctuation band; on the other, it does not take into account that the critical levet of the interest rate differentiai at which credibility is rejected varies with the length of the time horizon over which the credibility test is being conducted. These factors turn out to be important components of an adequate exchange rate credibility test.

©International Monetary Fund. Not for Redistribution 352 IOANNIS HALIKIAS

Figure 1. Recent Evolution of Exchange Rates

1.025 ,------,

BF/DM Exchange Rate (Nonnalized by the Central ERM Parity)

l.Q20

1.015

1.010

1.005

1.000

0.995 - ....- ... - - ...... - ...... - ...... - .... --...... - - .. ---- ......

1987 1988 1989 1990 1991 1992

Source: lMF, lnternational Financial Statistics.

©International Monetary Fund. Not for Redistribution THE CREDIBlLITY OF BELGIUM'S EXCHANGE RATE POLICY 353

Figure2. lnterest Rate Differentiais Versus Germany

8 r------,

Money market rate

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Source: lMF, International Financial Statistics.

©International Monetary Fund. Not for Redistribution 354 IOANNIS HALIKIAS

1. Interest Rate Corridors

An attractive way to overcome the above problems is the "interest rate corridor" approach.1 The underlying rationale is straightforward. Consider an N-month security denominated in DM. The annualized ex post BF rate of return R� on an investment in this security can be expressed as v = + N R� (1 i:N) e;N ' ( , y where i*N is the nominal interest rate of the security and e is the BF/DM spot exchange rate. A credible exchange rate zone would imply that the BF exchange rate is expected to fluctuate within a ± 2.25 percent band: � < e < e. With perfect capital mobility, and assuming no unexploited arbitrage opportu nities at equilibrium, credibility of the exchange regime implies that the interest rate of a BF-denominated security is constrained to move within a corridor: v (1 N � � + + ii�(;,y - 1 i� (1 ï:N)(�) 121N - 1. Two points regarding the above interest rate corridors are immediate!y apparent. First, for a gi ven German interest rate, a rise in e (that is, a BF weakening) shifts the corridor down, since, assuming exchange rate credibility, the weaker the domes tic currency, the higher is its potential appreciation and the lower its potential depreciation. Second, the shorter the time horizon, the greater is the width of the corridor, since the potential appreciation or depreciation per unit of time increases. In using interest rate corridors to assess exchange rate credibility, a fundamental asymmetry of the test should be stressed. Whereas a domestic interest rate above the corridor leads to a rejection of the credibility hypothesis, a domestic rate inside the corridor does not nec essarily imply credibility: although the hypothesis cannot be rejected, the hypothesis of an expected devaluation (upward shift in the corridor), such that the domestic in te rest rate would remain inside the new corridor, also cannot be rejected. Figure 3 depicts Belgian interest rate corridors for a fi ve-year horizon (based on the government bond yield) and for a three-month horizon (based on the money market rate). It is evident that short-run credibility

1 The interest rate corridor method was introduced by Svensson (1991) for the Swedish krona. lt was applied to the Belgian franc by Koen (1991).

©International Monetary Fund. Not for Redistribution THE CREDIBILITY OF BELGIUM'S EXCHANGE RATEPO LICY 355

Figure 3. lnterest Rate Corridors

t6 r------. Long-Tenn-Bond Yield

' ,•, ··"' . . ... •, \, ,• ·- ..... ' 8 """ ' ·.. . · .. , ·, . .., .:·"' .. -- ... , ... - " . . ·...... - · .., .. ..

...... · ...... 6 .,·· ··· ,· .,.' . ... 2.25 ... .. Corridor for percent ,_ .... , ...... exchange rate .. ... · · band · .,.

Three-Month Horizon-Money Market Rate 25 ' • .. . . . • .. 20 .. . . . : . . : . . . . 15 . . . ..

•', ...... 10

5 ' .. Corridor for . . . . 0.5 percent 0 . . Corridor for 2.25 percent rate . . exchange . band . . exchange rate band . . . 1 .. . -5 ...... \ . . · ' , ..... ' . . · ' ...... : . • . ' ..... : ,...... -10 ' · ...... · .. ":

-15 1982 1992

©International Monetary Fund. Not for Redistribution 356 IOANNIS HALIKIAS cannot be rejected, even assuming a very narrow implicit fluctuation band of ± 0.5 percent around the DM following the adoption of the "franc fort" policy. At the same time, it is clear that credibility did not come overnight: there are periods before 1986 for which even short-run credibility is rejected. On the other ha nd, the hypothesis of long-run credibility is rejected for the entire period, even though the Belgian Jong-term rate has been approaching the upper bound of its in te rest rate corridor over time. Th us, in line with Koen's (1991) conclusions, simple interest rate corridor analysis indicates that the Belgian hard currency policy is not yet credible for the long run, possibly reflecting questions regarding the credibility of overall economie management and the sustainability of the convergence of Belgium's economie fundamentals toward those of Germany. A major problem with simple interest rate corridor analysis is that it relies on the strong assumption of uncovered interest rate parity: it assumes, in other words, that interest rate differentiais reflect exclusively the expectation of exchange rate changes. To address this problem, the determinants of interest rate differentiais will have to be examined in more detail. This analysis will lead to a redefinition of the interest rate corridors appropriate for testing long-run exchange rate credibility.

II. Determinants of lnterest Rate Differentiais

This section discusses the formulation of a reduced-form equation that attempts to describe the Belgian-German long-term interest rate differ entiai (RB). The equation will be specified to enable a decomposition of the interest rate differentiai into an expected exchange rate change and a credit risk component. The latter, in turn, will be assumed to depend on Belgium's fiscal position relative to that of Germany. lt may be argued that, for a Western European country such as Bel gium, sovereign credit risk can be expected to be minimal, even with large fiscal imbalances. In that case, the interest rate corridors of the previous section would provide an adequate credibility test. In my view, this argument is questionable. Even if outright default could be ruled out,2 weaker forms of credit risk may still be present. In particular, sornetypes of debt rescheduling, mainly with regard to domestic institutional in-

2However, uncertainty over the constitutional future of Belgium, and the related recent proposais to allocate the central government debt to the regional sovernments could be relevant sources of credit risk. For a discussion of these Issues, see the central bank's views as reported in the Belgian daily L'Echo (1992).

©International Monetary Fund. Not for Redistribution THE CREDIBILITY OF BELGIUM'S EXCHANGE RATEPOLICY 357 vestors, are not unusual for countries of the European Union (EU). In addition, and perhaps even more relevant, individual countries retain taxation powers, and it is th us reasonable to assume that the market may be discounting the possibility of higher future withholding taxes in re sponse to major fiscal imbalances. These factors would also result in interest rate differentiais quite independent of expected future exchange rate movements. The specification assumes that expected changes in the BF/DM parity are driven by the expected Belgian-German inflation differentiai (INFLPR). In addition, expected parity changes are also assumed to be influenced by market perceptions of the extent to which the monetary authorities may desire to offset past !osses in competitiveness, captured by the difference in the annualized rate of change of the real effective exchange rate between Belgium and Germany (COMP).3 A time trend (TIME) is included to account for, among other things, autonomous changes in credibility over time. Finally, to capture the mechanics of the ERM, the following are included as relevant explanatory variables: a (0,1) dummy variable of general exchange rate realignments, not neces sarily involving the BF (REAL), and a devaluation variable (DEV) capturing the percentage point changes in the BF/DM central rate, whether as part of a general or a unilateral realignment. The hypothesis to be tested is whether REAL or DEV bad any impact on interest rate differentiais over the contemporaneous and two succeeding quarters. ln addition, an exchange rate regime term (REG) is included, taking the value 2.25 percent up to the second quarter of 1990 and 0.5 percent thereafter, to capture the impact of the "franc fort" policy. The REAL and DEV terms warrant further discussion. The rationale for including REAL is that, if a general realignment raises questions about the ERM itself, flows rnight be expected out of the perceived "weak" currencies toward the perceived "strong" currencies of the sys tem. Inclusion of the DEV term enables distinction between two conflict ing hypotheses: on the one band, if the new central rate is perceived by the markets to be more sustainable, support for the new parity may be achieved at a lower interest rate, thus implying a negative coefficient. On the other band, to the extent that a devaluation reveals information about the monetary authorities' reaction function and, in particular, if the markets view the devaluation as an indication that the authorities may again resort to this measure in the future in response to adverse trends in competitiveness or the real economy, a larger interest rate differen-

3 A rise in COMP signifies an improvement in relative competitiveness.

©International Monetary Fund. Not for Redistribution 358 IOANNISHALIKIAS tial may be required to hold domestic-currency-denominated assets, implying a positive DEY coefficient. The fiscal position is described by the debt/GDP ratio differentiai (DEBT) and the primary surplus/GDP ratio differentiai between Bel gium and Germany (DEFPR). If inflationary expectations are adequately specified, the fiscal variables may be expected to capture the credit risk component ofthe in te rest rate differentiai. The equation to be estimated, therefore, is

RB = llQ + a1INFLPR + a2DEBT + a3DEFPR + a4COMP + a5REAL + a6DEV + a,REG + a8TIME

+ a9COMP*TIME + E, where E stands for an error term. The cross term COMP*TIME was included to capture possible linear variation over time of the per ceived willingness to accommodate past !osses in competitiveness by an exchange rate adjustment. With regard to the error term, while it is assumed that it is zero mean, there are strong reasons why it may not be independently distributed. First, it is implausible to suppose that a new exchange rate system like the EMS inits early stages should be widely known and credible from the moment of its inception. In this respect, models of Bayesian learning about realignment probabilities like Driffill and Miller (1993) would predict seriai correlation in the error term of the above equation. Second, it would be reasonable to postulate that learning about the policy prefer ences of the monetary authorities can be a nontrivial exercise, particu larly as parameter estimates derived under a pre-EMS regime would be sensitive to the Lucas (1976) critique. Under these conditions, the au thorities may have to resort to signaling in order to reveal crucial aspects of their objective function. Signaling models in the spirit of Vickers (1986) would again predict seriai correlation of the error term.

m. Exchange Rate Risk Versus Credit Risk

To proceed with the estimation of the equation of the previous section, inflationary expectations need to be modeled. The simplest formulation would be to assume that the current inflation differentiai (INFL) is an adequate proxy for INFLPR. However, the estimation results of the above equation under this assumption appear to contradict this hypoth esis (t-statistics in parentheses):

©International Monetary Fund. Not for Redistribution THECREDIBILITY OF BELGIUM'S EXCHANGE RATEPOLICY 359

RB = -0.41 INFL + 0.029 DEBT + 0.508 DEFPR (0.20) (1.94) (4.46) -0.096 COMP - 0.0009 REAL + 0.188 DEV (3.77) (0.50) (2.56)

+ 0.410 REG - 0.0004TIME + 0.0014 INFL*TIME (1.95) (0.78) (1.83)

R2 = 0.87 jp = 0.85 F (11,30) = 48.9 SE = 0.0041

DW(1) = 2.01 DW(4) = 2.08 p, = +0.427(t = 2.41) P3 = -0.321(r = 2.18) The INFL coefficientturns out to be statistically insignificant,suggest ing that treating INFL as a proxy for INFLPR results in misspecification.4 As a consequence, the estimated coefficients of DEBT and DEFPR would be biased upward as, in addition to capturing the credit risk component of the interest rate differentiai, they may also reflect the perceived threat of debt monetization. Hence, the above formulation does not appear to offer a solid basis for the decomposition of the differentiai into an exchange rate risk and a credit risk component. In the face of this difficulty, expected inflation needs to be estimated. It is assumed that economie agents, in forming expectations of future inflation, take into account the past history of inflation, fi scal variables, and money supply growth (MON). In particular, in making an "optimal" prediction, they are assumed to make use of a "best-fit" equation linking present inflation to a distributed lag of the above variables. This methodology may be vulnerable to the "peso problem" analyzed by Krasker (1980). This problem arises when large parity changes are expected to occur infrequently, that is, they carry a low probability per unit of time. Un der these conditions, the probability that sample averages match "true" expectations is low, even in medium-sized samples. This situation is likely to be particularly relevant in a setting in which the monetary authority is perceived to be pursuing a mixture of fixed ex change rate and discretionary strategy of an "escape clause" type, studied by Flood and Isard (1989) and Cukierman (1990}--an attractive formal ization of a system of fixed but adjustable exchange rates. Under this

4 The results are not affected if the COMPvariable is replaced by the Belgian German ratio of the level of competitiveness, as defined by the respective real effective exchange rate indices.

©International Monetary Fund. Not for Redistribution 360 IOANNIS HALIKIAS strategy, the fixed exchange rate is expected to be maintained if shocks faU within a certain range, and to be abandoned if they faU outside that range.5 Presented below are the estimation results of such an equation, drop ping ali variables whose coefficients were statistically insignificant, and using broad money M2 as the relevant monetary aggregate.

INFL = 0.059 + 0.943 INFL(-1) - 0.324 INFL(-3) (4.36) (8.55) (2.86) +0.067 DEBT(-1) - 0.030 DEBT(-3) (2.81) (1.88) + 0.033 DEBT( -4) + 0.271 DEFPR( -1) (1.92) (2.41) + 0.267 DEFPR( -2) + 0.031 MON( -1) (1.87) (2.87) +0.045 MON(-3) + 0.045 MON(-4) (2.81) (2.83)

R2 = 0.98 ïP = 0.98 F (10, 29) = 159.2 SE = 0.0029 To estimate the equation of the previous section, the predicted infla tion differentiai from the above regression is included as a proxy for INFLPR. In the absence of credit risk, the fiscal variables, apart from their impact on expected inflation, should have no additional explanatory power. On the other band, if credit risk were nonnegligible, the coeffi cient of the fiscal variables, although lower than the corresponding esti mates of the equation using INFL as proxy for INFLPR, should still tum out to be statistically significant. The estimation results are

RB = 0.304 INFLPR + 0.018 DEBT + 0.313 DEFPR (2.50) (2.68) (4.71) -0.053 COMP + 0.0005 REAL + 0.215 DEV (2.27) (0.28) (2.59) + 0.366 REG + 0.0001 TIME + 0.0022 COMP*TIME (2.21) (0.42) (1.88)

5 On the other band, Radaelli's (1988) study of European onshore-offshore interest rates, suggesting that the markets have been reasonably accurate in forecasting the timing of realignments, can be interpreted as an indication that the bias resultin� from the peso problem may have been rather small. Also, Dombusch (1989) points to the flatness of the yield curve, which became inverted for many EMS countries, including Belgium, after 1990, as evidence that the peso problem may not be substantial.

R2 = 0.95 ïP = 0.93 F (11,25) = 43.6 SE = 0.0032

DW(l) = 1.96 DW(4) = 1.94 Pt = +0.307(t = 2.17) P4 = -0.195(t = 1.92) Dropping the statistically insignificant variables, the estimation results are

RB = 0.283 INFLPR + 0.019 DEBT + 0.319 DEFPR (2.65) (7.62) (5.19) -0.051 COMP + 0.192 DEV + 0.276 REG (2.11) (2.60) (2.28) + 0.0021 COMP*TIME (1.99)

R2 = 0.95 ïP = 0.94 F (9, 27) = 57.1 SE = 0.0031 DW(1) = 1.96 DW(4) = 1.90

Pt = +0.359(t = 2.28) P4 = -0.205(t = 1.93) The main results can be summarized as follows: (1) The constant term turned out to be statistically insignificant and was dropped from the regression. There is no evidence of a "structural" long-term interest rate differentiai between Belgium and Germany ema nating from imperfections in capital flows, imperfect asset substitutability owing, for example, to different liquidity characteristics, or other factors. (2) Expected inflation tums out to be statistically significant, despite the presence of a contemporaneous competitiveness term. The INFLPR coefficient is significantly less than unity. (3) The coefficients of the fiscal variables turned out to be statistically significant, albeit, as expected, lower relative to the estimates of the equation using INFL as proxy for INFLPR. The fiscal position appears to affect long-term interest rate differentiais independently of its impact on inflationary expectations. (4) The DEV coefficient turns out to be significant and positive, suggesting that a decision to devalue generates expectations of a recourse to this measure in the future as weil. Other things being equal, a 10 percent devaluation of the BF results in a 1.9 percent rise in the Belgian German long-term interest rate differentiai over the next three quarters. (5) The REG coefficient turns out to be positive and significant, suggesting that the announcement of the "franc fort" policy contributed to the narrowing of the Belgian-German interest rate differentiai by 0.5 percent.

Figure 4. Adjusted lnterest Rate Corridors (Long-Tenn Bond Yield)

. .. . . 1 .: 1 .. .

. . . . , \ ...... ,... t'\ . ... : . . �: . . . . 10 . . . . ' ...... · ' · .. · · · ...... : ! . · � : ...... ·:

. 8 . . . .

· : . .· · . .: ...... · ...· .. , . '•, · · ...... , . Adjusted corridor for percent . . . 6 2.25 '· :''\ .. exchangt ratt band •, .. /

1983 1984 198S 1986 1987 1988 1989 1990 1991 1992

(6) Finally, the COMP*TIME coefficient tums out to be statistically significant and opposite in sign to the COMP coefficient, suggesting that the monetary authorities have been perceived as progressively less willing to offset past losses in competitiveness through exchange rate ad justment. Because of the above observations, and particularly because the signif icance of the fiscal variables appears to extend beyond their impact on expected exchange rate movements, the interest rate corridors are now adjusted to test exchange rate credibility (Figure 4). In contrast to the results of Section I, long-term exchange rate credibility from 1990onward cao no longer be rejected.6 The fact that the Belgian bond yield bas remained above the corridor analyzed in Section I cao be explained by credit risk rather than exchange rate risk since 1990. These conclusions tum out to be robust with respect to a number of alternative specifications.' In particular, including the domestic and for eign components of debt separately to take into account the probable differences in the incentive to monetize associated with each one left the interest rate corridors of Figure 4 virtually unchanged . Furthermore. , consideration of a number of additional independent variables, such as unemployment and the extemal balance, suggested that these have no explanatory power with regard to interest rate differentials.8 Consider ation of a richer lag structure, derived from partial adjustment models, also bad no impact on the conclusions. Finally, the estimates of credit risk obtained from the above equation can be compared wi th alternative credit risk indicators, namely, Belgian German yield differentiais on government bonds denominated in deutsche mark and U .S. dollars. Although these indicators are hampered by data gaps and market illiquidity, they tend to faU within the 95 per cent confidence interval for credit risk obtained from a constrained version of the above regression. Even if the lower bound of the confi dence interval is used to adjust the interest rate corridor in Figure 4, the conclusions would not be significantly affected; the only difference is that nonrejection of the credibility hypothesis would be attained one quarter later.

6The timin g of the attainment of exchange rate credibility coïncides almost exactly with th e announcement of the "franc fort" policy. 7The relevant results are available from the author upon request. 8 This result cao be contrasted with Caramazza's (1993)conclus ions for France, which suggest that the authorities' exchange rate policy is perceived to be influ enced bythe - level of the unemployment rate and, to a lesser extent, by the change in foreign exchange reserves.

V. Summary and Policy Implications

The purpose of this paper was to test the credibility of Belgium's exchange rate policy, particularly because simple interest rate corridor analysis indicates that long-term credibility bas yet to be achieved, despite substantial progress in this area. To this end, the determinants of long-term interest rate differentiais were examined. The main conclusion was that fiscal variables appear to affect the interest rate differentiais quite independently of their impact o� inflationary expectations, and bence on anticipated exchange rate movements, th us raising questions about the assumption of interest rate parity, at least insofar as expected exchange rate movements exclusively refle.ct expected inflation differentiais. The interest rate corridors were adjusted accordingly, and it was concluded that long-term credibility can no longer be rejected. The specifie formulation of inflationary expectations chosen is some what arbitrary, despite its appealing features. A particular shortcoming is that this formulation does not take into account the impact of an nounced future policies. A more fundamental question is whether the fiscal variables may affect expected exchange rate changes through channels other than inflationary expectations. The importance of fiscal variables in affecting long-term interest rate differentiais can be quantified in a straightforward way: given the current fiscal position, the estimation results suggest that the primary surplus must rise to about 8 percent of GDP for Belgium to attain long-term interest rate equalization relative to Germany. This estimate is con servative, as it presupposes that Belgium's inflation will remain below Germany's over the near future. Even though the breakdown of the impact of the fiscal variables into an effect that works through expected exchange rate movements and an effe.ct related to credit risk may not be of practical significance for the overall interest rate differentiai per se, it is sufficiently important to be worth pursuing. In addition to its relevance for the problem of optimal debt financing, it also indicates that long-term interest rate differentiais may persist, even if the ERM becomes more credible over time, or indeed after the introduction of a single European currency. Thus, the analysis highlights the importance of fiscal consolidation as a policy priority, as the current fiscal imbalances are con tribu ting to the persistence of the long-term interest rate differentiai vis-à-vis Germany. The findings suggest that this effect works through two main channels: (1) the impact of the fiscal variables on inflationary expectations, reflect-

©International Monetary Fund. Not for Redistribution THE CREDIBILITY OF BELGIUM'S EXCHANGE RATE POLICY 365 ing the perceived incentive of the authorities to monet iz e the large public debt and (2) a credit ri sk component. This paper had been largely completed before the decision to widen the EMS band from 2.25 percent to 15 percent was reached in August 1993. Although the new band, if fully exploited, may arguably be re garded as effectively equivalent to floating for most EU currencies, the analysis of exchange rate credibility largely retains its relevance. First, the widening of the band was conceived as a temporary measure in response to the currency turmoil, with the aim of re-establishing the narrow band in the future. Second, and perhaps more important, it is not too likely that a small, open economy like Belgium would opt for pure floating even during the transition period of the wider fluctuation band. In fact, the Belgian monetary authorities' policy response to the widening of the band was to raise short-term rates, white indicating that they would pursue a policy of unilaterally pegging the Belgian franc close to its old band vis-à-vis the deutsche mark. Under these conditions, although the results in this paper on exchange rate credibility may be sensitive to sorne extent to the institutional framework-particularly with regard to inter vention by other EMS central banks that is now mandatory only when a currency reaches the boundary of its 15 percent band-they can still shed sorne light on the feasibility of unilaterally pegging the exchange rate without reintroducing capital controls.

REFERENCES

Barro, Robert J., and David B. Gordon, "Rules, Discretion and Reputation in a Mode! ofMonetary Policy," Journal of Monetary Economies , Vol. 12 (July 1983), pp. 101-121. Caramazza, Francesco, "French-German lnterest Rate Differentiais and Tîme Varying Realignment Risk," Staff Papers , International Monetary Fund, Vol. 40 (September 1993), pp. 567-83. Cukierman, Alex, "Fixed Parities Versus a Commonly Managed Currency and the Case Against 'Stage Two'" (unpublished; Tel Aviv University, June 1990). Dornbusch, Rudiger, "Europe 1992: Macroeconomie Implications," Brookings Papers on Economie Activity:2 (1989), pp. 341-81. Driffill, John, and Marcus Miller, "Learning and Inflation Convergence in the ERM," Economie Journal, Vol. 103 (March 1993), pp. 369-78. L'Echo , "Banque Nationale: Non à la Dette Federalisée," June 23, 1992, p. 1. Flood, Robert, and Peterlsard, "Simple Rules, Discretion and Monetary Policy," NBER Working Paper 2934, National Bureau of Economie Research (April 1989).

Giavazzi, Francesco, and Marco Pagano, "The Advantage ofTying One's Hands: EMS Discipline and Central Bank Credibility," European Economie Re view, Vol. 32 (June 1988), pp. 1055-75. Koen, Vincent R., "Tes ting the Credibility of the Belgian Hard Currency Policy," IMF Working Paper 91J79 (Washington: International Monetary Fund, 1991). Krasker, William S., "The 'Peso Problem' in Testing the Efficiency of Forward Exchange Markets," Journal of Monetary Economies , Vol. 6 (April 1980), pp. 269-76. Lucas, Robert E., Jr., "Econometrie Policy Evaluation: A Critique," Journalof Monetary Economies 1, Supplementary Series (1976), pp. 19-46. Radaelli, Giorgio, "EMS Stability, Capital Controls, and Foreign Exchange Market Intervention," Greek Economie Review, Vol. 10, No.l (1988), pp. 133-61. Svensson, Lars E.O.,"The Simplest Test of Target Zone Credibility," Staff Papers , International Monetary Fund, Vol. 38 (September 1991), pp. 655-65. Vickers, John, "Signalling in a Mode! of Monetary Policy with Incomplete Information," Oxford Economie Papers , Vol. 38 (November 1986), pp. 443-55.