Moving the Escudo into the Euro

When the 1987 general elections brought a durable government to Portugal, the national environment was still inflationary. Nevertheless, thanks to the efforts of successive ministers of finance/central bank governor pairs, the criteria for Economic and Monetary Union (EMU) were met and the seventh pair saw the euro conversion rate be set at 200 escudos. The agreed rate represents a depreciation of some 16% over the one at which the escudo entered the ECU basket in 1989. As the change in regime towards stability-oriented macroeconomic policies was completed when the parity grid of the Exchange Rate Mechanism of the European Monetary System (ERM) was under severe stress, escudo depreciations were agreed upon at realignments initiated by the peseta. The understanding by the Portuguese authorities of the ERM code of conduct as they prepared to join after the 1991 general elections made it possible to acquire financial reputation very quickly. But the enhanced national credibility abroad caused tension within several minister/governor pairs, especially with respect to the timing of ERM entry, the speed at which to move to full currency convertibility and whether the escudo should respond to peseta realignments. Moreover, both the opposition and the governing party initially resisted the stability-oriented policy, stalling structural reforms and allowing the opposition to win the 1995 general elections on a reformist platform. As a consequence, the stability-oriented policy was maintained until EMU qualification but there were no other major reforms, rasing the threat of a "euro hold-up". The weekly escudo-DMark rate reveals widely different volatility states which were accompanied by six successive exchange rate regimes. Before entering the ERM, a crawling peg was discreetly replaced by DMark shadowing with reinforced controls on capital inflows at the beginning of first stage of EMU. Yet, the escudo-DMark rate, even allowing for the last realignment, was more stable in the ERM than when it was inconvertible and the central bank controlled the currency. The comparison excludes the subperiod of crises before widening the bands and the one after volatility in prospective EMU qualifying currencies subsided. Markov switching autoregressive conditional heteroskedasticity (SWARCH) models with more than three states capture all regimes. The specification with five states is favored because it suggests the nature of the response of the central bank to speculative attacks during the crises regime.