Exchange Rate Pegging: Credibility and Fundamentals. Evidence from Greece

Abstract

The paper examines the predictability of a currency-peg collapse on the basis of the movements of underlying fundamentals and the observed behaviour of currency markets. Our findings suggest that the ultimate collapse of a peg is predictable if the peg is inconsistent with valid long-run macroeconomic relationships. A strong currency policy is confirmed to be helpful in terms of reducing inflation but its prolonged implementation reduces the peg’s credibility. In the case-study examined, markets appear to have anticipated the peg’s collapse almost a year before it occurred. However, the results show that the exact timing of the devaluation took markets by surprise. Even under conditions of devaluation expectations, central banks have the capacity to surprise the markets.