Regime-switching in Exchange Rate Policy and Balance Sheet Effects

36 Pages Posted: 20 Jul 2005  

Norbert M. Fiess

World Bank

Rashmi Shankar

World Bank

Date Written: July 2005

Abstract

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.

Keywords: Markov regime switching, balance sheet effects, exchange market intervention

JEL Classification: F310, F340

Suggested Citation

Fiess, Norbert M. and Shankar, Rashmi, Regime-switching in Exchange Rate Policy and Balance Sheet Effects (July 2005). World Bank Policy Research Working Paper No. 3653. Available at SSRN: https://ssrn.com/abstract=757824

Norbert M. Fiess (Contact Author)

World Bank ( email )

1818 H Street, N.W.
Washington, DC 20433
United States

Rashmi Shankar

World Bank ( email )

1818 H Street N.W.
Washington, DC 20433
United States

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