metadata: authors: 0: author: Serven,Luis
1: author: Frankel,Jeffrey A.
2: author: Fajnzylber,Eduardo
3: author: Schmukler,Sergio L.
count: Iceland,Chile
docna: 0: docna: Verifying exchange rate regimes
docty: Policy Research Working Paper
subtopic: Consumption,Fiscal & Monetary Policy,Investment and Investment Climate,Currencies and Exchange Rates,International Trade and Trade Rules,Inflation
teratopic: Information and Communication Technologies,Macroeconomics and Economic Growth,Environment,Finance and Financial Sector Development
abstracts: cdata!: Credibility and transparency are at the
            core of the current debate about exchange rate regimes. The
            steady growth in the magnitude and variability of
            international capital flows has complicated the question of
            whether to use floating, fixed, or intermediate exchange
            rate regimes. Emerging market economies are abandoning
            basket pegs, crawling pegs, bands, adjustable pegs, and
            various combinations of these. One of several reasons
            intermediate regimes have fallen out of favor is that they
            are not transparent; it is very difficult to verify them.
            Verifiability is a concrete example of the principle of
            "transparency" so often invoked in discussions of
            the new international financial architecture but so seldom
            made precise. A simple peg or a simple float may be easier
            for market participants to verify than a more complicated
            intermediate regime. The authors investigate how difficult
            it is for investors to verify from observable data whether
            the authorities are in fact following the exchange rate
            regime they claim to be following. Of the various
            intermediate regimes, they focus on basket pegs with bands.
            Statistically, it can take a surprisingly long span of data
            for an econometrician or investor to verify whether such a
            regime is actually in operation. The authors find that
            verification becomes more difficult as the regime's
            bands widen or more currencies enter the basket peg. At the
            other extreme, they also analyze regimes described as the
            regime's bands widen or more currencies enter the
            basket peg. At the other extreme, they also analyze regimes
            described as free floating and find that in some cases the
            observed exchange rate data do validate the announced regime.
geo_reg_key: 119228,517190,517191
repnme: repnme: Verifying exchange rate regimes
display_title: Verifying exchange rate regimes
listing_relative_url: /research/2000/07/436959/verifying-exchange-rate-regimes
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Exchange Rate Policy m1327143 1124,Macroeconomic and Structural Policies
            m1327380 439,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Information and Communication Technologies,Macroeconomics and Economic Growth,Environment,Finance and Financial Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 72
author_keys: 0: author_key: 93728
1: author_key: 435764
2: author_key: 440099
3: author_key: 142794
model_extractions: POLICY RESEARCH WORKING PAPER **2397**

# **Summary findings**

Credibility and transparency are at the core of the current debate about exchange rate regimes. The steady growth in the magnitude and variability of international capital flows has complicated the question of whether to use floating, fixed, or intermediate exchange rate regimes.

Emerging market economies are abandoning basket pegs, crawling pegs, bands, adjustable pegs, and various combinations of these.

One of several reasons intermediate regimes have fallen out of favor is that they are not transparent; it is very difficult to verify them. Verifiability is a concrete example of the principle of "transparency" so often invoked in discussions of the new international financial architecture but so seldom made precise. **A** simple peg or a simple float may be easier for market participants to verify than a more complicated intermediate regime.

Frankel, Fajnzylber, Schmukler, and Serv6n investigate how difficult it is for investors to verify from observable data whether the authorities are in fact following the exchange rate regime they claim to be following.

**Of** the various intermediate regimes, they focus on basket pegs with bands. Statistically, it can take a surprisingly long span of data for an econometrician or investor to verify whether such a regime is actually in operation.

The authors find that verification becomes more difficult as the regime's bands widen or more currencies enter the basket peg.

At the other extreme, they also analyze regimes described as free floating and find that in some cases the observed exchange rate data do validate the announced regime.

This paper-a joint product of Macroeconomics and Growth, Development Research Group, and the Regional Studies Program, Latin America and the Caribbean Region-is part of a larger effort in the Bank to understand alternative currency regimes. Copies of the paper are available free from the World Bank, **1818** H Street NW, Washington, **DC** 20433. Please contact Emily Khine, room **MC3 -347,** telephone **202-473-7471,** fax 202-522-3518, email address kkhine@worldbank.org. Policy Research Working Papers are also posted on the Web at w gw.worldbank.org/research/workingpapers. The authors may be contacted at jeffrey_frankel@harvard.edu, efajnzyl hucla.edu, sschmukler@worldbank.org, or Iserven @worldbank.org. July 2000. (64 pages)

> _The Polcy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective ofthe series is toget the findings out quickly, even ifthe presentations are less than_ **_fully_** _polished. The papers carry the names ofthe authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

Produced **by** the Policy Research Dissemination Center
# **Verifying Exchange Rate Regimes**

Jeffrey Frankel _Harvard University and NBER_ Eduardo Fajnzylber _University of California, Los Angeles_ Sergio Schmukler _World Bank_ Luis Serv6n _World Bank_

**JEL** Classification Codes: **F31, F32, F33, F36**

Keywords: verifiability, transparency, exchange rate regimes, basket peg, bands, target zone, floating

**-** We are grateful to Sebastian Edwards, Miguel Kiguel, Javier Ortiz, Ilan Goldfajn, and participants at the NBER/CEMA Inter-American Seminar on Economics for their useful feedback. Changqing Sun performed excellent research assistance work. We also thank Klaus Schmidt-Hebbel, Roberto Steiner, Matias Tapia Gonzalez, Alejandro Werner, and Roberto Zahler for making their data available to us. This paper was prepared as part of the Regional Studies Program of the Latin American and Caribbean Region of the World Bank.

E-mail addresses: **jeffiey** frankel(harvard.edu, efajnzvl(ucla.edu, sschmukler(wworldbank.orM Iserven@worldbank.org
# **I.** Introduction and The Corners Hypothesis

The choice of exchange rate regime **-** floating, fixed, or somewhere in between **-** is an old question in international monetary economics. But the steady increase in magnitude and variability of international capital flows has complicated the question. This is particularly the case for the developing countries that in the 1990s became fullfledged participants in international financial markets.

**A** major new element in the debate is the proposition that emerging market countries are, or should be, abandoning basket pegs, crawling pegs, bands, adjustable pegs, and various combinations of these. The currently-fashionable view is that countries are being pushed to the "corners," the extremes of either free floating or firm fixing. The intermediate regimes are said to be no longer viable. This proposition is variously called the hypothesis of the vanishing intermediate regime, the missing middle, or the comers solution. Its life history has gone from birth to conventional wisdom in a remarkably short period of time.

The motivation of this paper is the observation that, as fashionable as this proposition has become, few of its proponents, if any, have offered an analytical rationale for it, let alone a fully worked out theoretical model. Our aim is to offer a possible theoretical rationale. We seek to introduce the notion of _verifiability,_ and to suggest that a simple peg or a simple float may be more verifiable **by** market participants **than** a more complicated intermediate regime. Verifiability is a concrete instance of the more general principle of "transparency" that is so often invoked in recent discussions of the new international financial architecture but so seldom made precise.
# **La** Motivation

Consider the exchange rate regime that a number of emerging markets had in the 1990s: a band around a central parity that itself is a basket with a rate of crawl. So far as existing theory is concerned, the complexity of this arrangement has no implications for its credibility. But, in truth, when a central bank announces a regime of this type, the public has no way of verifying quickly, **by** observing the exchange rate, whether the central bank is doing what it claims to be doing.

**A** central bank does not earn credibility merely **by** announcing a monetary regime with a nominal anchor such as the exchange rate, even if its intentions are sincere. The public will judge credibility from data available to it. If the announced exchange rate regime is a simple dollar peg, a market participant need only check that the exchange rate today is the same as the exchange rate yesterday, in order to verify that the central bank is indeed following its announced policy. **If** the announced regime is a pure float, a participant can essentially check every month whether the central bank has intervened in the market **by** seeing whether its reserve holdings have changed. Under the basket band, **by** contrast, the market participant needs more months of data in order to be able to verify that the central bank is indeed implementing the announced policy. When comparing the corners, simple pegs tend to be more immediately verifiable than floating regimes. Typically, a market participant needs some extra piece of information, like reserves, or more data to check that an exchange rate is truly floating. How many months of data he or she needs is the central analytical exercise of this paper.

We are not claiming that verifiability is necessarily the complete story behind the purported non-viability of intermediate regimes. And we are certainly not claiming that it 2
> is the only criterion, or even the most important criterion, in the larger debate about fixed and floating exchange rate regimes. Many other factors, whether from the traditional optimum currency area literature or the newer criteria associated with credibility and financial markets, need to be taken into account.1 Our goal is rather to offer an attempt at what, so far as we are aware, may be the first explicit analytical rationale for the proposition that intermediate regimes are less viable than the corner regimes.

In this paper, we demonstrate the difficulties of verifiability for the case of a band around a basket peg. We believe that the same difficulties apply to other intermediate exchange rate regimes, such as a managed float or adjustable peg. One could model a managed float, as a central target and a central bank policy of intervening partially to offset market forces when they push the exchange rate away from that target. But one would have to estimate the central target, and measure somehow the pressure of current market forces in order to figure out to what extent the authorities were intervening to resist them, a difficult econometric exercise. One could model an adjustable peg as a fixed exchange rate with an escape clause: the central bank has an explicit or implicit rule of abandoning the peg when an exogenous shock of a particular size occurs, and when a particular percentage of its foreign exchange reserves have been exhausted. Verifying that sort of rule would be even harder than the others because usually few relevant observations will occur in the sample period, and even when the adjustment takes place, there is little way in practice of verifying whether on the one hand the putative exogenous shock in fact occurred, or on the other hand the government's commitment to monetary discipline was not sincere in the first place. We choose to explore verifiability for the case of the basket band rather than the other examples because it is a cleaner econometric 'Two recent reviews are Larrain and Velasco **(1999)** and Frankel **(1999). 3**
exercise. We also look at countries that are believed to be floating, to offer a contrast to those that are believed to follow basket bands.

This paper explores the amount of information that it takes for market participants to verify announced exchange rate regimes from observed data. The goal of the paper is to show the difficulty to verify exchange rate regimes and how this varies with regimes. To our knowledge, this is the first paper that performs this type of exercise. We use observed exchange rate data and simulated data to provide empirical estimates. The fact that countries vary their exchange rate regime over time allows us to run this experiment for regimes of different complexity.

Regarding bands, the paper confirms the intuitive notion that wide bands are harder to verify than narrow bands. It is often difficult or impossible to estimate the weights of the central parity with only one or two years of data. Regarding regimes announced as free-floating, the paper shows that in some cases the exchange rates observed under such regimes are correlated with those of major currencies. In this sense, they behave similarly to the basket countries. It is not straightforward to verify them, when only using exchange rate data.

To complement the tests performed with real data, we run Monte Carlo experiments to obtain more general conclusions and to provide results regarding the amount of information necessary to estimate regimes of interest. Monte Carlo experiments, displayed in the Appendix, confirm that more complex regimes take a larger amount of data to be verified. The Monte Carlo exercise shows the role of a number of factors in determining verifiability: the band size, number of currencies in the basket, the rate of crawl, sample period, periodic adjustments of the central parity. The results 4
> confirm the intuition that the amount of information necessary to verify the exchange rate regimes increases with the complexity of the regime.

The rest of the paper is organized as follows. The rest of the introduction introduces the verifiability problem. Section II describes the framework and empirical strategy used to verify exchange rate regimes. Section III presents estimations for the case of exchange rate bands. Section IV shows the results from free-floating regimes. The main conclusions are summarized in Section V. Appendix 1 displays a small Monte Carlo exercise extending the study of regime verification to simulated models, and Appendix 2 gives more details on the construction of the numeraire and the estimated models.

# **Lb Intellectual Origins of the Corners Hypothesis**

What is **known about the** origins of the hypothesis of the vanishing intermediate regime? The original reference is believed to be Eichengreen (1994). The context was not emerging markets, but rather the European Exchange Rate Mechanism. The ERM crisis of **1992** and band-widening of **1993** suggested to some that a gradual transition to European Economic and Monetary Union, where the width of the target zone was narrowed in steps, might not be the best way to proceed after all. (Crockett, 1994, made the same point.) Obstfeld and Rogoff **_(1995)_** concluded, **"A** careful examination of the genesis of speculative attacks suggests that even broad-band systems in the current **EMS** style pose difficulties, and that there is little, if any, comfortable middle ground between floating rates and the adoption **by** countries of a common currency." The lesson that "the

**5**
best way to cross a chasm is in a single jump" was seemingly borne out subsequently, **by** the successful leap from wide bands to **EMU** in **1998-99.** After the East Asia crises of **1997-98,** the hypothesis of the vanishing intermediate regime was applied to emerging markets. In the effort to "reform the international financial architecture" so as to minimize the frequency and severity of crisis in the future, the proposition was rapidly adopted **by** the international financial establishment as the new conventional wisdom.

For example, Summers **(1** 999a)<sup>2</sup> : "There is no single answer, but in light of recent experience what is perhaps becoming increasingly clear **-** and will probably be increasingly reflected in the advice that the international community offers **-** is that in a world of freely flowing capital there is shrinking scope for countries to occupy the middle ground of fixed but adjustable pegs. As we go forward from the events of the past eighteen months, **I** expect<sup>thatcountries</sup> will be increasingly wary about committing themselves to fixed exchange rates, whatever the temptations these may offer in the short run, unless they are also prepared to dedicate policy wholeheartedly to their support and establish extra-ordinary domestic<sup>safeguards</sup> to keep them in place." Other high-profile examples include Eichengreen **(1999, p.10**<sup>**4**</sup> **-10**<sup>**5**</sup> **),** MintonBeddoes **(1999)** and Council on Foreign Relations **(1999, p.87).** The International Monetary Fund has now agreed that countries that get into trouble **by** following<sup>an</sup> intermediate regime will in the future not be bailed out, though it qualified<sup>thescopeof</sup>

> 2 Other high-profile examples include Eichengreen **(1999, p.104-105),** Minton-Beddoes **(1999)** and Council on Foreign Relations **(1999, p.87).**

**6**
the generalization a bit, for example, **by** allowing a possible exception for "systemically" important countries.

It may be that the _Economist_ **(1999, p.15-1**<sup>**6**</sup> **)** is right that "Most academics now believe that only radical solutions will work: either currencies must float freely, or they must be tightly tied (through a currency board or, even better, currency unions)." But the proposition remains to be modeled, let alone proven. It seems intuitively right that these countries, facing finicky international investors and rapidly disappearing foreign exchange reserves, had little alternative but to abandon their pegs and baskets and bands and crawls and move to a float, unless they were prepared to go to the opposite corner. But what is the rationale for this proposition?

# I.c Lack of Theoretical Foundations

What is the analytical rationale for the hypothesis of the disappearing intermediate regime (or the "missing middle")? Surprisingly, none currently exists, to our knowledge.

At first glance, it appears to be a corollary to the principle of the Impossible Trinity.' That principle says that a country must give up one of three goals: exchange rate stability, monetary independence, and financial market integration. It cannot have all three simultaneously. If one adds the observation that financial markets are steadily becoming more and more integrated internationally, that forces the choice down to giving up on exchange rate stability or giving up on monetary independence. But this is not the

> **3** Summers **(1999b, p. 326)** is explicit: "...the core principle of monetary economics is a trilemma: that

> capital mobility, an independent monetary policy, and the maintenance of a fixed exchange rate objective are mutually incompatible. I suspect this means that as capital market integration increases, countries will be forced increasingly to more pure _floating_ or more purely fixed exchange rate regimes."

**7**
same thing as saying one cannot give up on _both, that_ one cannot have half-stability and half-independence. There is nothing in existing theory, for example, that prevents a country from pursuing a target zone of moderate width. The elegant line of target-zone theory begun **by** Krugman **(1991),** in which speculation helped stabilize the currency, always assumed perfect capital mobility. Similarly, there is nothing that prevents the government from pursuing a managed float in which half of every fluctuation in demand for its currency is accommodated **by** intervention and half is allowed to be reflected in the exchange rate. (To model this, one need only introduce a "leaning against the wind" central bank reaction function into a standard monetary model of exchange rate determination.) And there is nothing that prevents a country from pursuing a peg that is abandoned whenever there is a shock large enough to use up half its reserves.

Another justification that has been offered is that when a government establishes any sort of exchange rate target, as did the East Asian countries, its banks and firms foolishly underestimate the possibility of a future break in the currency value.<sup>4</sup> As a result, they incur large unhedged dollar liabilities abroad. When a devaluation occurs, their domestic-currency revenues are inadequate for servicing their debts, and so they go bankrupt, with devastating consequences for the economy. "It follows that in a world of high capital mobility there are only two feasible approaches to exchange rate policy. One is not just to peg the exchange rate, but to lock it in **-** the Argentine strategy... .The vast majority of countries will **...** have to follow the other alternative of allowing their currencies to fluctuate. **If** the exchange rate moves regularly, banks and firns will have an incentive to hedge their foreign exposures..." (Eichengreen, **1999, p.105).**

**8**
There is little doubt that the focus on unhedged foreign-currency debt describes accurately why the **1997-98** devaluations were economically devastating to East Asia. But the argument, as stated, has some weaknesses. First, it appears to depend on irrationality on the part of banks and firms. Second, it appears to imply that a country would be better off **by** gratuitously introducing extra noise into the exchange rate, to deter borrowers from incurring unhedged dollar liabilities. This seems unlikely to be right. Third is the point emphasized **by** Ricardo Hausmann: because foreigners are unwilling to take open positions in the currencies of emerging-market countries, the admonition to avoid borrowing in dollars is to some extent an admonition to avoid borrowing at all. (An admonition to hedge the dollar exposure is not helpful; someone has to take the other side of the futures contract, and this will be difficult in the aggregate if foreigners are unwilling to take the open position.) It may well be that this is the right road to go down, that exchange rate volatility is a way to put some sand in the wheels of the excessive capital movements, and that a lower volume of total debt is a good outcome. But if this is the argument, the proponents should be explicit about it. In any case, it seems doubtful that this argument could be captured **by** conventional models.

**A** third possible justification is that governments that adopt an exchange rate target, and sometime later experience a major reversal of capital inflows, tend to wait too late before abandoning the target. As of **1998,** we thought we had learned that the one thing an emerging-market government can do to minimize the eventual pain from a currency crisis is to try to devalue early enough (or else raise interest rates early enough, as would happen automatically under a currency board **-** anything to adjust, rather than

> 4 The version of this argument in Eichengreen **(1999,** p.104) overstates the extent to which the East Asians had "a stated commitment to the peg," as most commentators have done as well. In fact few of the East

**9**
try to finance an ongoing deficit). Mexico, Thailand and Korea made the mistake of waiting too long, until reserves ran very low, so that **by** the time of the devaluation there was no good way out, no combination of interest rates and exchange rate that would simultaneously satisfy the financing constraint externally and prevent recession domestically. But exiting from an exchange rate target can be difficult politically. The lesson is drawn that, to avoid this difficulty, governments should either adopt a rigid institutional fixed-rate commitment (such as the currency boards of Hong Kong and Argentina), or, if not prepared to do that, abandon the peg early. **5** On this basis, when Brazil in the autumn of **1998** delayed the seemingly inevitable jettisoning of the _real_ target, many thought this would be a repeat of the earlier mistakes. Instead, when the devaluation finally came in January **1999,** Brazil's trade balance improved sharply, the lack of confidence subsided, and output and employment subsequently performed far better than in neighboring Argentina. Thus it is more difficult to generalize from recent experience than widely believed. Furthermore, if we are to use government reluctance to exit a target arrangement as the basis of a model of the unviability of intermediate regimes, it seems that we would again require some sort of irrationality **(or** political constraints<sup>6</sup> ) on the part of policy-makers.

Thus, each of the three arguments offered **-** the impossible trinity, the dangers of unhedged dollar liabilities, and the political difficulty of exiting **-** contains some important truth. But none seems able to stand as a theoretical rationale for the superiority

> Asian countries had explicit dollar pegs.

> s Even then we had a counter-example: Indonesia had widened the band right away in **1997,** and yet that didn't save it. But one could argue that political instability would have done Indonesia in no matter what. Taiwan devalued promptly, and suffered less than the others.

> **6** Governments may have an incentive to postpone devaluations until after elections. See Ernesto Stein and Jorge Streb **(1998, 1999).**

**10**
of the corner solutions over the intermediate regimes. Is the corners hypothesis, then, just a misplaced manifestation of the temptation to believe that the grass is always greener somewhere else?

# **II.** Assessing **Verifiability**

The idea behind verifiability is that the government's announcement of an exchange rate regime is more likely to be credible if market participants can check for themselves from observable data that the announced regime is in fact in operation. Specifically, the goal of our paper is to study how long it takes for financial markets to identify from the data the rules guiding the intervention behavior of the authorities in the foreign exchange markets The process of verification can be modeled along the lines of statistical inference familiar to econometricians. We are not suggesting that market participants will literally run **OLS** or other sorts of regressions, but rather that they must do something similar implicitly to process the available information.

The paper's framework encompasses a broad variety of regimes **-** simple and basket pegs with bands and crawl as well as floating regimes. However, if a country follows an exact basket peg (i.e., with no band), the problem of statistical inference is of limited interest.<sup>7</sup> In practice, however, there is almost always some range of variation in the observed exchange rate data, even if it is only within a narrow bid-ask spread quoted **by** the banking system, or within the **_+/-_ 1%** range that constituted a fixed exchange rate under the rules of the Bretton Woods system. Then the problem of statistical inference is 11
not trivial. For bands of substantial width, the statistical inference can in fact be difficult, as we shall see. This is all the more true if one allows for the ever-present possibility of shifts in the parameters-basket weights, band width, rate of crawl, or level of parity-or changes in the regime altogether, especially if some of these shifts are not announced.

In our empirical analysis, we work with a set of emerging countries, for which we know the announced exchange rate regimes. We will begin with an analysis of the basket bands followed **by** Chile and Israel during the late 1980s and 1990s.8 Given that Chile and Israel changed their band parameters over time, we are able to examine them under different regime configurations. Then, we move on to the regimes officially declared as floating followed **by** Brazil, Mexico, Peru, South Korea, and Thailand.

If the currency in question is in fact following a basket band, the question of interest is how many data points are necessary, i.e., how much time must elapse, in order to verify that the regime is in fact in operation. In general, we will consider an anchored exchange rate regime to have been verified if it passes two tests. **(1)** We fail to reject the hypothesis that the exchange rate is following the announced basket peg. (2) We can find statistically significant basket parameters, i.e., can reject the hypothesis that the currency is behaving like any "random" currency. These two tests are informative only if they have adequate power. To judge the power of the tests, we perform the same tests with a randomly generated variable and with a freely floating exchange rate as the dependent variable. When using these latter variables we should reject the null hypothesis in **(1)** and fail to reject that in (2). In the case of floating regimes, since there are no announced

> In that case, the announcement of a basket of **N** major currencies can be verified with **N+1** observations, which is the number needed to estimate exactly the basket weights. As noted, however, this does not constitute verification of an adjustable peg since we don't observe the terms **of** the "escape clause." **A** detailed description of these regimes can be found in Appendix Tables **A.1** and **A.2.**

12
pegs we only use the second test. Below we specify more explicitly the null hypotheses

## under consideration.

**If** an announced regime of basket bands does not pass these tests, one can argue that it is not verifiable, which suggests that the country cannot reap the credibility gains that an anchored exchange rate regime theoretically offers-credibility in the eyes of workers and producers who set wages and prices, and in the eyes of speculators who have the ability to attack the central bank's reserves and bring about a crisis. **If** viability requires verifiability, such a regime may not be viable.

In the case of bands, we are especially interested also in seeing how the ability to confirm the announced nominal regime is statistically affected **by** features such as the width of the band and the number of foreign currencies in the basket.

Our approach focuses on the empirical estimation of the parameters describing the exchange rate rule at different sample sizes **-** e.g., **_50,_ 100,** and 200 observations. The point estimates, their precision, and the tests of the above hypotheses constructed using them tell us how well can market participants identify the parameters of the regime when the latter is **10,** 20, and 40 weeks old. For this empirical analysis, we need a basic framework and a testing procedure. The rest of this section is devoted to these questions.

# **IIa Basic Framework**

**We adopt a** general formulation to "nest" a number of alternative regimes. We assume that the exchange rate for a given small country is given **by** a weighted

**13**
> combination of **_N_** foreign currencies, with a possible rate of crawl **_d_** and an error term.

> The exchange rate is:<sup>9</sup>

where _st_ **is** the spot exchange rate of the domestic currency with its value measured in terms of a numeraire that we will explain momentarily; _s,_ are the spot exchange rates of the major "strong currencies" measured vis-A-vis the same numeraire; **_d_** is the rate of crawl, which for now is assumed to be fixed during a given sample period;<sup>10</sup> and _wi_ are the weights given to the currencies included in the basket. Depending on the specification of the basket, **(D** may take different forms, with the simplest one being the familiar _D(w,i,,-:=Ywisi,t._

# **_Simple Pegs, Basket Pegs, Crawling Pegs, Crawling Baskets_**

This general case captures many possible regimes, including simple pegs, basket pegs, crawling pegs, crawling baskets, target zones, certain forms of managed floating, and free floating. In the case of simple pegs, the value of the currency follows the exchange rates of the foreign currency to which it is pegged, plus the crawling rule, and a stochastic error. The latter is the error allowed or incurred **by** the government when setting the exchange rate. In the case of simple pegs, **_N_** (the number of currencies in the basket) is equal to one. Under basket pegs, **_N_** is bigger than one. Crawling pegs imply that **d>O.** Under crawling baskets, **N>l** and **d>O.**

> **9** The precise models that we estimated are described in Appendix 2, which also provides a description of the procedure followed **by** Chile and Israel to construct the basket used as central parity in their band systems.

14
In the case of an exact peg, the error term would vanish, and an **OLS** regression of the domestic currency on the foreign currencies to which it is pegged would yield an 1l equal to **1.** Verification is a trivial exercise, whether the peg is simple or to a basket. This can be easily illustrated **by** examining the behavior of the central parity in band regimes. Central parities behave like simple or basket pegs (with or without crawl), depending on the regime. Frankel, Schmukler and Serv6n (2000) report estimations of a version of equation **(1)** above using as dependent variable the Chilean peso central parity. In all the cases examined there, the weights of the central parity converge to their announced values almost immediately. In our present context, the pegged regime is verified instantaneously. Thus, in the remainder of this paper we concentrate on the cases of exchange rate bands (target zones) and floating regimes.

# **_Target Zones_**

In a regime of target zones, a central parity is defined as a function of a single or multiple foreign currencies and the exchange rate is allowed to float within a prespecified band around this central parity. Whenever it hits the boundary, the government intervenes to keep the exchange rate inside the band. In many cases, governments make intra-band interventions as well.

In a target zone, the log difference between the observed spot exchange rate and the central parity, **_st*,_** is determined **by** the following equation:

**b** if _s_ **<** **_-b_** _s,_ **={b** **_ifs, >_ b** _vt_ otherwise

> **10** One alternative would be to use past domestic or future inflation rates relative to international inflation

**_15_**
where _st_ is defined **by** equation **(1)** above and **b** is the band width.

According to theory, the distribution of _v_ can be quite complicated. Even under two simplifying _assumptions_ made **by** Krugman **(1991)** in a famous article that generated a sub-field of research on target zones-that the band is **100%** credible and that the authorities intervene only at the boundaries-the distribution is not normal, but rather follows a particular S-shape." But extensive empirical investigation of the European Exchange Rate Mechanism in the 1980s and early 1990s established that the spot rate does not in fact obey the predicted distribution. There are a number of likely reasons for this, among them the lack. of **full** credibility of the zones<sup>12</sup> and the prevalence of intramarginal intervention.

For these reasons we shall assume in our work that _v_ follows instead an autoregressive process, of the form vt **=** _pv-l_ **_+_** _ut,_ where _u_ is iid. In fact, we will focus on the random walk case of **_p =_ 1,** in accordance with most time series analyses of exchange rates, which cannot reject the unit root hypothesis.<sup>3</sup> rates, where the authorities are believed to be following an indexation policy.

**"** When the spot rate draws close to one edge, speculators are aware that there is a limit on how far it can continue to move in that direction. The expected value will show a regression back toward the central parity. As speculators respond to that expectation, they will push the spot rate away from the margin, even without any intervention.

> **12** Imperfect credibility was in the event justified **by** realignments in the early 1980s, and especially **by** the ERM crises of **1992-93.** It is also relevant for the present exercise, which is entirely based on a starting point that assumes imperfect credibility.

> **13** In unreported results, we found that estimates of **p** were practically **I** in most regressions using equation **(1).** One extension for further research would be to use statistical distributions implied **by** more sophisticated versions of the target zone theory. Another would be to take the observed statistical distribution from historical episodes such as the ERM currencies in the 1980s or 1990s.

**16**
# **_Managed Floating and Free Floating_**

While there are many possible patterns of exchange rate intervention, our basic framework [equation **(1)]** only allows us to test whether **_d_** or _w;_ are different from **0.** In other words, the government is using some form of nominal anchor or crawling peg rule 14 to guide its operations. Other forms<sup>of interventionarenot nested inour specification</sup> Hence, we will consider that failure to reject that **_d=O_** and _wi=0_ is a characterization of a pure floating regime. **15** In such case, the disturbance term accounts for the entire variance of the exchange rate.

# **_The Choice of Numeraire_**

The question of what to use as the numeraire to measure the values of the domestic and foreign currencies is a surprisingly subtle one. In the case of exact pegs it makes no difference **-** so long of course as the same one is used for both dependent and independent variables alike. The correct weights should emerge, with a perfect statistical fit, regardless of the numeraire. But in the general case, the choice of numeraire does make a difference. Past studies have used a variety of numeraires, including the consumer basket of domestic goods (Frankel, **1993,** which emphasized Asian currencies), the SDR (Frankel and Wei, **1995,** which emphasized policies of European currencies), the Swiss franc (Frankel and Wei, 1994 and Ohno, **1999)** and the dollar (Benassy-Quere, **1999).**

> 14 It is possible to assume that the government follows a variance-reducing form of intervention but, without imposing some a priori value for the variance of the underlying process, it is not possible to identify the intervention parameter.

> **15** We use the term free-floating to refer to a case where there is no correlation between the studied currency and any of the strong currencies. It is possible to argue that under pure free-floating, market forces might induce some correlation with the currencies of major trade partners.

**17**
Upon further reflection, these measures are not quite right. We wish to consider regimes where the central bank monitors a central parity, but routinely allows appreciations or depreciations relative to that parity in response to such factors as inflation, unemployment, trade deficits or surpluses, various market pressures and so on. These factors are only partially accommodated under an intermediate regime such as a band or managed float, but they have a role nonetheless. We have not chosen to model explicitly these factors; they are comprised **by** the error term. The authorities are presumed to be trading off the long-term credibility benefits of sticking relatively close to their central nominal parity against the monetary-independence benefits of responding to short-term developments. But in framing this tradeoff, there is no reason for them to think of the departure above or below the central parity in terms of dollars or a basket of goods, and still less reason to think in terms of Swiss francs. The most useful way to phrase these appreciations and depreciations is, rather, in terms of an effective exchange rate, that is, a weighted average of trading partners' currencies.

In this paper we measure values of currencies in terms of a weighted basket of the **G7** currencies. One possible set of weights is the bilateral trade shares of the smaller country in question. This has a drawback: it leaves out the role of all the other bilateral trade partners, as well as third-country markets and competitors. But most of those are linked to some combination of the major currencies. Here we adopt the simple approach of using the **G7** countries' weights in gross world production. In this way it is hoped that, for example, the large weight of the **US** will roughly reflect the importance of dollarlinked countries in the trade of Chile or Indonesia beyond the share of the **US** in bilateral

**18**
trade of those two countries.'<sup>**6**</sup> Thus, the exchange rates, both of the major currencies and

> the currencies under study, are calculated as the number of units of the currency necessary to purchase a weighted basket of strong currencies.<sup>7</sup>

# **II.b** Empirical Strategy

We use daily data in our empirical experiments.1<sup>8</sup> To assess how verifiable different exchange rate regimes are, we use explicit statistical tests that attempt to replicate those implicitly carried out **by** financial market participants to learn about the actions of the monetary authorities. For countries that have announced a basket band **-** such as Chile and Israel during the sample periods we use (examined in section III below), we seek to establish the amount of information (days) needed to reach a judgment on whether the data support the hypothesis that the exchange rate is following the announced regime. In the case of currencies that have declared their regime as a pure float **-** like post-crisis Mexico and Thailand (section IV below) **-** the purpose of the exercise is to offer a standard of comparison for the first set of currencies.

**A** test that fails to reject the announced regime for the currencies following basket bands, has low power if the same test also fails to reject an analogous hypothesis applied to floating currencies. We wish to see whether the public can distinguish the two sorts of policies statistically, rather than having to rely on the assumption that it can instantaneously intuit the true policy of their central bank.

> **16 A** second advantage of using **GDP** weights is that one does not need to obtain the full set of bilateral trade data and recompute a new set of weights for each country. But using bilateral trade weights is a possible extension for future research.

> **17** See Appendix 2 for a detailed description of the construction of the numeraire.

> **'** Data on major currencies and some of the emerging countries was extracted from Bloomberg and Datastream. Data for the case studies of Chile and Israel was downloaded from the respective Central Banks Web pages.

**19**
To make this approach operational, we summarize the exchange rate regime in terms of the basket weights in equation **(1).** Tests of hypotheses about the exchange rate regime then are just tests of hypotheses regarding the basket weights. The tests we perform are the following.

Test 1 (TI): Market participants test whether the weights obtained from empirical estimation of equation **(1)** are equal to the announced weights. Conditional on the announcement being true, we expect that this null will not be rejected. The null and alternative hypotheses are: HO: _wi=_ announced weights; **HA:** _w,#_ announced weights.

Test 2 (T2): The second test inquires more generally, whether we can reject that the currency is freely floating. We assume that market participants do not know what the government is doing, for example because the government has not explicitly announced a regime, or else they do not necessarily believe the announced exchange rate regime. **The** null hypothesis is that the value of the currency follows a random walk with or without drift. Therefore, we think of market participants as testing if all the weights on the strong currencies are jointly equal to zero. Formally,

> _HO: w;=_ **_0_ ...** and **...** wv,= **0; HA:** wI#0 **...** **_or..._** _wN_ **_#_ 0.**

One problem with this approach is that Test **I** might fail to reject the null due to lack of power --e.g., if we work with too short a time sample. Market participants know instinctively that a failure to reject the regime is an informative finding only when that test would be capable of rejecting the regime in the case where it was false. To see if Test **1** has power, we complement it with another experiment in which we replace the dependent variable with fictitious data and with a floating exchange rate. Then, we test 20
the null hypothesis that the weights are equal to the ones announced **by** Chile and Israel. We perform this experiment for the cases in which Test 1 fails to reject the null hypothesis. In this experiment, we expect to reject the null, given that we are using false weights. Analogously, to check that Test 2 is not rejecting the null hypothesis when it is true (i.e., it is not making a Type **I** error), we perform a similar experiment for Test 2. In this case, we should fail to reject the null hypothesis of Test **2.19** To estimate equation **(1)** and carry out inference on its parameters, a variety of procedures are potentially applicable. In this paper we report results using a "naive" estimation procedure, which we implicitly assume to be the one that market participants apply to process the observed data. Specifically, we compute **OLS** estimates of equation **(1)** in first differences. We do this for all the exchange rate regimes explored in the paper.<sup>20</sup> While nre complex models, such as those derived from the recent target zone literature, might offer some advantage in terms of consistency, their estimation would also require a vastly larger amount of data. Therefore, we work with these relatively simple specifications to carry out our tests and illustrate the point of the paper.

As independent variables for the basket band regimes, we use those currencies that were included in the announced basket. In some cases we found that some of these currencies were strongly correlated over some periods (particularly the Deutsche mark and French franc, both included in the Israeli basket), so that the estimations were plagued **by** severe multicollinearity and identification of the specific weights was almost

> **19** Alternatively to T2, which checks the null that all weights are zero, we used another test of the null that all the strong currencies have the same weight, obtaining very similar rejection frequencies.

> **20** The estimated models are described in Appendix 2. We also experimented with more general error-

> correction models allowing for long-run equilibrium and short-run dynamics, with the long-term relationship linking the level of the domestic exchange rate with the level of the strong-currency exchange rates. In general precision was poor, and the long-run equilibrium poorly identified. To save space, we don't report the results here.

21
impossible. To solve this problem, we opted for computing also estimates of a "restricted" model combining the most **highly** correlated currencies, using the ratio of their announced weights. We return to this below.

# **III. Verifying Exchange Rate Bands**

Using the framework and empirical approach just described, this section focuses on the verifiability of the exchange rate bands followed **by** Chile and Israel over recent years.

# **III.a Chile**

> **A** number of successive exchange rate regimes have been in place in Chile since the early **1980s.**<sup>**2**</sup> **1** In **1982,** Chile had a crawling peg vis-A-vis the **US** dollar, with daily devaluations following the difference between domestic and external inflation. The peg to the dollar continued until **1992,** with bands of varying width around the central parity and with realignments of the central parity. In **1992,** the government decided to adopt a target zone around a basket peg. The weights on the currencies defining the central parity changed over time and there were realignments, but the central parity was always tied to the **US** dollar **(US$),** the Deutsche mark (DM), and the Japanese yen **(JY).** Finally, in September **1999** the central bank decided to float the peso.

The entire period of exchange rate bands can be broken down into a number of sub-periods distinguished **by** different levels of the central parity, basket composition and band width. To analyze the verifiability of Chile's exchange rate band system, we focus

> **21 A** detailed chronology of the exchange rate system in Chile is presented in Table **A.** 1 in the appendix.

22
on seven of those sub-periods, selected on the basis of a minimum duration (specifically, those comprising at least 249 daily observations, amounting to approximately one year). The relevant parameters characterizing these sub-periods are summarized in Table La. The first three sub-periods involve a peg to the **US** dollar with a band, while the last four involve a basket peg with a band.

Figure **1** displays the observed exchange rate in terms of the weighted basket numeraire, along with the announced bands. The figure shows that the trend of the peso has been to depreciate over time, with significant appreciations and depreciations on several occasions, and highlights the fluctuations of the exchange rate within the band, as well as the gradual widening of the latter. In some periods, like **1991-92,** the exchange rate is close to the lower band. In other periods, like **1994-95,** the exchange rate fluctuates farther inside the band. After suffering pressure on the peso, the authorities decided to narrow the band from 12% to **3.5%** in September **1998** to show their commitment to the value of the peso. The band was widened back to **8%** in December **1998.** Table **1.b** reports the results of the verifiability tests using the Chilean exchange rate data, based on first-difference **OLS** estimates of the basic equation. For each of the seven sub-periods under consideration, the table presents the cumulative rejection frequencies of the null hypotheses of Test **1** and Test 2 at increasing sample sizes **-** **_50,_ 100** and 200 observations. For example, a rejection frequency of **100** for **50** observations in Test 2 means that in **100** percent of the estimations with sample sizes smaller than **50** we can reject the null hypothesis that the weights are equal to **0.2** In addition, the table also reports point estimates and standard errors of the weight of the **US$** in the basket

**23**
defining the central parity (to save space, we omit the estimated weights of the other currencies). Finally, the last two columns of the table give a measure of the precision of the estimates, in terms of their mean absolute error **-** that is, the sum of absolute deviations of the estimated weights from their announced values.<sup>23</sup> For periods 4-7, when the central parity is defined **by** a basket of several currencies, the table presents two sets of results. The first set is based on an unrestricted version of the model, in which we attempt to estimate the individual weights of all currencies in the basket. As already mentioned, however, this procedure may run into difficulties due to the high correlation among some of these currencies in some subperiods, and therefore we also present results from a restricted model version combining the most highly-correlated currencies in the proportions dictated **by** the announced weights. In the Chilean case, this involved combining in such fashion the **US** dollar and the yen.<sup>24</sup> The results in Table **1.b** show a clear difference between periods **1-3** and 4-7, regardless of whether we use the restricted or unrestricted model in the latter sub-periods. In the former sub-periods, the point estimates of the **US** dollar weight approach fairly quickly the announced weight (equal to one), especially in periods 1-2. In these two periods the estimated weights are not statistically different from the announced value (Test **1),** but are statistically different from zero (Test 2) for any sample size. In turn, in sub-period **3,** with an increased bandwidth (equal to **_5%)_** relative to periods 1-2, the point estimate of the **US** dollar weight still approaches its announced value, although at a

> **22** The first estimation starts with the minimum number of observations required to estimate the models.

> **23** Since the announced weights sum up to **1,** no rescaling is required.

> **24** The correlation between the first differences of these two currencies exceeds **_.85_** in some of the subperiods of analysis.

24
somewhat slower pace than in periods 1-2. However, we also find a higher rejection rate in Test **I** and a somewhat reduced rejection rate in Test 2. On the whole, these results tend to suggest that the widening band makes verification more difficult.

In contrast, for periods 4-7, characterized **by** a currency basket and much wider bands, none of the estimates in Table **lb -** whether restricted or unrestricted **-** appears close to the announced values even after a reasonably large number of observations. Precision is much poorer than in the earlier periods, although the restricted estimates are in general substantially more precise than the unrestricted ones (see the last two columns in the table). In any case, both sets of estimates appear clearly biased; indeed, some point estimates are even negative. As a result, while Test 2 generally rejects the null of zero weights, Test **1** also rejects the announced weights in most samples, and this applies both to the restricted and unrestricted estimates.

These results can be more easily understood with the help of Figure **3,** which presents scatter plots of the observed exchange rate of the Chilean peso against the central parity. In the first three sub-periods, the points cluster along the 45-degree line, reflecting a relatively close match between the peso and the central parity. As the band widens in the last four periods, the peso can fluctuate further away from the central parity. This is particularly apparent in periods **5-7,** whose scatter plots display little or no clustering along the 45-degree line. Thus, it is not surprising that in the first three periods the basket weights defining the central parity can be estimated fairly precisely from the observed exchange rate data, while this is not the case in later periods.<sup>2 5</sup>

> 2' The scatter diagram, along with Figure **1,** also provides some clues for the relatively poorer verifiability of the third period vis-h-vis the first two. In the early part of the third period (approximately **_50_**

> observations), the exchange rate was practically pegged to the upper part of the band, but starting in early

> **1990** the peso started appreciating until it finally reached the lower band. This marked break in the

**_25_**
On the whole, the results for Chile strongly suggest that the widening of the band, together with the adoption of multiple instead of simple pegs, make verification of the announced regime more difficult using simple econometric estimates. **26**

# **III.b Israel**

Israel presents another interesting experience of basket band with weight changes and progressive widening of the band. During the periods on which we will focus, the band included the same five currencies **[US** dollar **(US$),** Deutsche mark (DM), British pound (BP), French franc (FF), and Japanese yen **(JY)]** and the bandwidth rose from **3%** to **_15%._** The Bank of Israel had already introduced an exchange rate band around a basket in **1976.27** It lasted for a year before being replaced with a floating exchange rate, followed in turn **by** a dollar peg in **1985** and a basket peg in **1986,** with basket weights determined **by** trade shares and subject to relatively frequent revisions.<sup>28</sup> At the beginning of **1989,** the Bank of Israel reintroduced a band system **by** allowing the exchange rate to fluctuate within a region of **±3%** around the currency basket defined **by** the five currencies already mentioned. The band was later widened to

> trajectory of the peso, clearly visible from the scatter plot in Figure **3,** is behind the poorer performance of Tests 1 and 2 in the third period that is apparent _from_ Table **lb.**

> **26** One could object that the contrast between the results we obtain for the earlier and later periods of Chile's band regime might be due instead to some underlying change in the behavior of the strong currencies or in the way the peso moved within the band. However, the intuition that verifiability is more difficult with wider bands and baskets with more currencies is confirmed **by** the Monte Carlo experiments in Appendix **1,** which are not subject to those objections.

> **27** For a detailed account of the exchange rate policy in Israel, see http://www.bankisrael.gov.il and Appendix Table **A.2.**

**28** The number of units of each currency in the new basket was originally determined according to its share in trade during the previous calendar year and to international cross rates. Since then, the trade shares were revised annually and when significant changes produced, the weights and units in the basket were recalculated. The number of units of each currency in the basket is kept constant, but its weight **-**

**26**
**_5%_** in March **1990, 7%** in May **1995,** and then gradually since June **1997,** to reach **_15%_ by** the end of that year.<sup>29</sup> Most importantly, since December **1991** a pre-announced, constant rate of crawl was added to both the midpoint and the band **-** a system known as a crawling band.

Figure 2 shows the evolution of the Israeli exchange rate and the exchange rate band. One feature that stands out is the frequency of realignments of the central parity, particularly in the early years of the band. For the analysis of verifiability, we divided the sample into different sub-periods characterized **by** different bandwidth, basket weights and/or rate of crawl of the exchange rate band. Table 2.a lists the periods under consideration, their beginning and ending dates, and the relevant parameters of the band.

In the case of Israel, collinearity among basket currencies is more of an issue than in Chile due to the larger number of currencies and, especially, to the simultaneous inclusion of the French franc and DM in the basket. **30** Thus, for the restricted model estimation we combined the DM with the franc and the **US** dollar with the yen, using in each period the ratio of announced weights.

The empirical results for Israel are reported in Table **2.b,** which is analogous to Table **1.b** for Chile. It is apparent from the table that the exchange rate system can be unambiguously verified **by** our procedure only in the third sub-period (labeled 2.2 in the table), when the announced weights cannot be rejected **by** Test **1** and zero weights are clearly rejected **by** Test 2 **-** particularly when using the restricted model estimates. In the

> understood as the share in the total _cost_ of the basket **-** can change daily according to changes in cross rates (see Appendix 2 for more details).

> **29** Appendix Table **A.2** provides more details on the developments of exchange rate policy in Israel since **1986.**

> **3o** The correlation between these two currencies exceeds **.98** in some of the sub-periods under consideration.

**27**
other sub-periods, the unrestricted estimates wander off very far from the announced values, and lead to rejection of both null hypotheses in the majority of cases, even though their precision is extremely poor. In turn, the restricted estimates are much more precise, and generally closer to the announced weights. In general, they lead to rejection of the null of zero weights for sufficiently large samples in all sub-periods, but tend also to lead eventually **to** rejection of the announced weights except in period 2.2.

Like in the case of Chile, the scatter plots presented in Figure 4 help understand these empirical results. Period 2.2 is the only one in which the observed exchange rate behaved in a fashion similar to the central parity. During this period, which coincides with the introduction of a crawl in the path of the central parity, the exchange rate hovered around the midpoint of the band, and the boundaries were never reached.

In contrast, during periods 1 and 2.1 the frequent level adjustments to the band already mentioned are reflected in the disconnected scatter plots of Figure 4. From the perspective of verifiability, these jumps make identification of the basket weights more difficult. Finally, in the wider-band periods **3-6,** the scatter plots are more reminiscent of those corresponding to the multiple-currency periods of the Chilean band: they show little correspondence between the central parity and the observed exchange rate.

In summary, one interpretation for the poor verifiability results in the Israeli case probably lies in the additional complexity induced **by** the presence of five mutually correlated currencies in the central basket. Even after reducing to three the number of regressors, identification is still poor. The sharp discontinuous changes in the central parity in the earlier periods, and the augmented band width in the later ones, are also likely obstacles to the verification of the regime.

**28**
# **III.c Is the Test Informative?**

**We** conclude this section with a reassessment of the robustness of _our_ findings for the cases in which we achieved verification (periods 1-2 in Chile and 2.2 in Israel). We do this **by** constructing a randomly generated variable and using it to replace the observed exchange rate as dependent variable in the empirical estimation and testing procedures performed earlier. The results are reported in Table **3,** from which it is apparent that Test **1** rejects the announced weights in most cases, and Test 2 fails to reject the zero weights in all the cases. This suggests that problems with test power are not behind the success in verifying the exchange regime in these episodes.

As a final exercise to reassess the robustness of our findings, we replace the Chilean peso and the Israeli shekel with the Swiss franc. We choose the Swiss franc because Switzerland had a floating regime during the periods of interest. Table **3** shows that we reject the null hypothesis that the weights are equal to the announced weights. As reported before, for the same periods, the estimations with the Chilean peso and the Israeli shekel fail to reject the announced weights. Therefore, one can conclude that periods 1-2 in Chile and period 2.2 in Israel are verifiable.

Table **3** also shows that the Swiss franc rejects the null hypothesis that the weights are equal to zero. This rejection does not mean that the Swiss franc is not freely floating during the periods under consideration. Exchange rates are correlated for other reasons **than** government intervention. This tends to yield rejections of zero correlation. The next section of the paper explores whether it is possible to fail to reject free floating using the methodology applied for band regimes.

**29**
# **IV.** Verifying Free-Floating Regimes

We now turn to the verification of free-floating regimes. The concept of verifiability has a different meaning under floating regimes. Under these regimes, governments do not make a commitment to a nominal anchor. There are no exchange rate rules to be verified, except that the exchange rate is floating or that the government is not intervening in the market. Applying the methodology used for exchange rate bands, market participants can check if the exchange rate is uncorrelated with major exchange rates.

**A** rejection of no correlation is not a rejection of a free-floating regime. Using observed exchange rate data, it is generally difficult to fail to reject that weights are equal to zero, either because governments intervene or because exchange rates co-move. Rejecting zero weights is not necessarily a sign of intervention. However, failing to reject zero weights is a clear sign of no intervention (or no pegging to other currencies). We rejected zero weights in the case of the Swiss franc above. Now, we move to the case of emerging markets.

Before proceeding with the estimations, note that there are other alternative ways of verifying free-floating regimes. Market participants can essentially check every month whether the central bank has intervened **by** seeing whether its reserve holdings have changed. Also, banks usually know who is participating in the market, so they can tell the difference between a system where the central bank never intervenes and where it intervenes occasionally. These methods require some type of additional information,

**_30_**
beyond observed exchange rates. In this paper, for ease of comparison with the previous section, we stick to verifiability just using exchange rate data.

For the verification of floating regimes, we focus on Brazil, Mexico, Peru, South Korea, and Thailand during specific periods in the 1990s. These countries provide a good opportunity to compare periods of intervention with periods of free-floating. Brazil, Mexico, South Korea, and Thailand suffered exchange rate crises in the 1990s, which forced them to abandon previous exchange rate arrangements and adopt systems officially described as free-floating **by** their respective authorities. Therefore, for these countries we perform the same statistical tests for periods labeled as free floating and for periods during which other regimes were in operation **-** namely periods of managed floating, bands, crawling pegs, and basket pegs. Peru, on the other hand, is an interesting case because despite declaring a free-floating regime for the entire decade, several papers have noted that the Peruvian exchange rate has remained surprisingly steady. (See Calvo and Reinhart, 2000, Hausmann, Panizza, and Stein, 2000, and Edwards and Savastano, **1999,** for characterizations of floating regimes.) As in other cases, the observed pattern calls into question whether the government is in truth following the regime that it says.

Following the methodology used in the previous section, we estimate our basic equation **(1)** for each of these countries over the periods noted in Table 4 and dictated **by** data availability over the 1990s. We allow for a constant rate of crawl, include as regressors the five major currencies **(US** dollar, yen, DM, British pound and French franc), and as before estimate the model **by OLS** in first differences.<sup>3'</sup>

> **3t** As we are only testing the hypothesis of all the weights being equal to zero (a standard goodness of fit test), we are not concerned **by** the potential multicollinearity problem.

**31**
In free-floating regimes, we expect to fail to find any peg of the exchange rate visi-vis foreign exchange rates, so we would expect Test 2 not to reject the null of zero weights. Table 4 reports the percentage of observations for which the test does reject the null hypothesis that weights are equal to zero. **If** the exchange rate is in fact free-floating, one would expect to find low values in the table, meaning that we only find a relationship between the local currency and strong currencies in very rare occasions. On the other hand, when the central bank follows a specific rule relative to one or several strong currencies, we expect to find large values in the tables (mostly rejections of the hypothesis that weights are equal to zero).

For ease of comparison, the shaded areas in Table 4 correspond to periods labeled as free-floating. The results displayed in the table show that in the case of pegs, bands, and managed floating regimes we reject in almost every sample the null hypothesis that the weights are equal to zero. The only exception is the case of Brazil, during part of her period of managed floating. On the other hand, in the episodes declared as free-floating we generally fail to reject the same hypothesis. There are two exceptions, however: Peru and most of the post-Tequila period in Mexico.

The samples used for the tests reported in Table 4 start at the beginning of the year except when a specific date is known for the transition to floating. As an alternative approach, Figure **_5_** shows the rejection percentage (right-hand scale) of the zero-weights hypothesis in rolling samples of **100** observations during the 1990s, together with the exchange rate vis-A-vis the **US$** (in the left-hand scale).

The pattern is similar to that shown in Table 4. It is possible to see how rejection rates fall dramatically right after a major devaluation in the three countries affected **by** the

**32**
late 1990s crisis: Brazil, Korea, and Thailand. In the last two cases, we observe a similar pattern in the sense that after approximately one year has elapsed since the large devaluation, rejection rates appear to rise again. In the Mexican case, rejection rates fall only during short periods after the late 1994 crisis. Much interest has been devoted to the Mexican free-floating regime that followed the Tequila episode of 1994, particularly during the stable period starting in late **_1995._** Edwards and Savastano **(1998)** found that the volatility of the exchange during **1996** was not smaller than that of other currencies widely considered as free-floating, but there seemed to be some form of feedback rule from the exchange rate to monetary policy.

Finally, it is also clear from the figure that periods of marked stability of the exchange rate are matched **by** rejections of the zero-weights hypothesis. Examples of this are the Brazilian band period **(1995-1998),** the Korean, Mexican, and Thai pre-crisis periods, and the Peruvian free-floating regime of the 1990s.

# V. Summary **and Concluding Remarks**

The new conventional wisdom is that intermediate exchange rate regimes, such as baskets, crawls, and bands, are no longer viable. According to this proposition, countries are being pushed to the "corners," the extremes of either free floating or **firm** fixing. We have argued that a theoretical rationale for this proposition is currently lacking; none of the candidates offered **-** the impossible trinity, the dangers of unhedged foreign liabilities, or government reluctance to abandon ship in time **-** is quite up to the **job.** We offered such a rationale, **by** introducing the notion of _verifiability._ **By** verifiability we mean the ability of a market participant to infer statistically from observed data that the exchange

**33**
rate regime announced **by** the authority is in fact in operation. Verifiability is an instance of transparency, a means to credibility. Our point is that a simple regime such as a clear dollar peg, or even a free float, may be more verifiable **by** market participants than a complicated intermediate regime.

In this paper we have made a first attempt at assessing empirically the verifiability of various exchange rate regimes. We first focused on the verification of exchange rate bands, drawing from the experiences of Chile and Israel. In the case of Chile, when the band was relatively narrow and the peg involved only the dollar, verification is relatively easy to achieve. But from **1992** to **1999,** when the band became wider and the peg involved additional currencies, our simple statistical procedures fail to achieve verification. In the case of Israel, whose basket involved five currencies, two of which were very strongly correlated, we only achieve verification in a period of relatively narrow band in which the central parity does not experience sharp realignments, and only when using a restricted specification involving a reduced number of currencies. In widerband periods, and in narrow-band periods with frequent realignments, our procedures again fail to achieve verification of the regime. This is precisely the result we expected.

On the whole, the results suggest that higher bandwidth, as well as the adoption of multiple instead of simple basket pegs, and frequent parity realignments, all make more difficult the econometric verification of the announced regime.

The finding that Chile and Israel fail to reject the announced weights for some particular periods seems to be an informative test. For the same time periods, we reject those weights when we replaced the peso and shekel **by** a randomly generated variable 34
and **by** the Swiss franc. This means that for narrow bands we are able to verify the announced exchange rate regime.

We also examined the verifiability of regimes self-declared as free floating in several Latin American and East Asian countries in the 1990s **-** Brazil, Mexico, Peru, South Korea, and Thailand. Even though there are different ways to verify floating regimes, we followed the same methodology used for bands. We tested whether supposedly floating exchange rates are correlated with major exchange rates. Our tests do not show significant evidence against the hypothesis that the exchange rates of these countries are indeed floating, with the exception of Peru and part of the post-Tequila period in Mexico. In these cases, we find some evidence that the exchange rate is in fact moving along with some weighted combination of strong currencies. This appears to agree with the conclusions reached **by** other researchers. In sum, we fail to reject freefloating regimes, although cross-currency correlations tend to reject free-floating **-** even when governments do not intervene. Whether these findings can be extended for long periods of free floating, after the high volatility in the aftermath of crises has vanished, is a question for future research.

The analysis in the main text was complemented **by** means of Monte Carlo tests reported in Appendix 1 assessing the effects of bandwidth and number of currencies in the basket on the time needed to verify exchange rate bands. On the whole, the results agree with the above findings. As expected, when the range of variability of the exchange rate is relatively large, the number of observations needed to verify the regime increases considerably with the width of the band. The number of observations needed to differentiate the crawling basket from a random variable in at least half of the samples is

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under **100** days when the band width is 2%, as it was for Chile from **_1985_** to **1987,** but is over **500** days when the band width is **10%,** as it was for Chile from **1992** to **1998.** Regarding the role of the number of currencies in the basket, we find that moving from a single-currency parity to a 3-currency basket increases the amount of data needed to distinguish the basket from a random currency **by** an extra year's worth of observations (assuming a **10%** band, and again using the criterion of finding statistically significant weights at least half the time).

If we are right that it is hard for a central bank to establish credibility for its proclaimed monetary regime without verifiability, then our results confirm that complicated combinations of baskets, crawls, and bands, are less likely to satisfy skeptical investors than are simpler regimes. We thus offer a possible and much-needed rationale for the hypothesis of the vanishing intermediate exchange rate regime.

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