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Regime-Switching in Exchange Rate Policy and Balance Sheet Effects

  • Norbert Fiess
  • Rashmi Shankar

It is well accepted that exchange rate policy in many emerging markets has been characterized by shifts between a stronger and weaker commitment to peg. This raises the following questions, which we address in our paper: Does intervention policy exhibit clearly defined and periodic shifts? What drives this policy variability? We identify clearly defined switches between high and low intervention in all the countries in our sample. We also find strong evidence that balance sheet effects, proxied by the stock ratio of external liabilities to assets, and economic performance, as measured by GDP and stock market indices, determine the likelihood of the regime shift. Specifically, an increase in reserve currency debt raises potential capital losses from devaluation and reduces the probability of switching to a low intervention regime. We use a panel of quarterly data starting 1985 through 2004 for a sample of 15 countries, mostly from East Asia and Latin America. We adopt a novel two-step empirical strategy in this paper. First, we measure the policy response of the central bank in two ways, both derived from the monetarist model: a standard exchange market pressure index and a model-based volatility ratio that is endogenized relative to Japan, our “benchmark” floater. We apply regime-switching methods to these “policy response indices.” This generates a time-series of unconditional probabilities of switching between high and low intervention. In the second step, we establish a set of variables that explains changes in these probabilities

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2005_16.

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Date of creation: Jul 2005
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Handle: RePEc:gla:glaewp:2005_16
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  1. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
  2. Reinhart, Carmen & Kaminsky, Graciela & Vegh, Carlos, 2004. "When it rains, it pours: Procyclical capital flows and macroeconomic policies," MPRA Paper 13883, University Library of Munich, Germany.
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  18. Aart Kraay & Norman Loayza & Luis Serven & Jaume Ventura, 2000. "Country Portfolios," NBER Working Papers 7795, National Bureau of Economic Research, Inc.
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