The Credibility of Cabo Verde's Currency Peg

Abstract

This paper studies the credibility of the currency peg of Cape Verde (CV) by assessing the impact of economic fundamentals, our explanatory variables, on the stochastic properties of Exchange Market Pressure (EMP), the dependent variable, using EGARCH-M models. Our EMP descriptive analysis finds a substantial reduction in the number of crisis episodes and of (unconditional) volatility after the peg's adoption. Moreover, our estimation results suggest that mean EMP is driven by fundamentals and that conditional variability is more sensitive to negative shocks.

We also find evidence that the expected return from holding CV's assets is lower under the currency peg for the same increase in monthly volatility. The reason is that the return's composition is "more virtuous", as it results from the strengthening of CV's foreign reserve position and is not due to either a larger risk premium or favourable exchange rate movements. We take this to be a sign of the credibility of the peg, which apparently reflects the intertemporal credibility of CV's economic policy and so has successfully withstood international markets' scrutiny.

Keywords: Currency Peg, Exchange Market Pressure, EGARCH-M

JEL Classification: C22, F31, F33