Introduction

Since its inauguration in March 1979, the Exchange-Rate Mechanism (ERM) of the European Monetary System (EMS) has functioned with the aid of frequent currency realignments – to date, more than one per year on average. In the eyes of many observers, the strategy of frequent realignment has allowed the system to survive in spite of the rather divergent macroeconomic policies pursued by the ‘Big Three’ of the EMS, France, Germany, and Italy. An apparently critical element in minimising the financial disruption caused by realignments has been the control over cross-border financial flows maintained by France and Italy. The large onshore-offshore interest differentials that have emerged during currency crises suggest that capital controls have played an important role in insulating the French and Italian financial systems from the full force of speculative capital movements.

Current and planned measures liberalising the external capital accounts of France and Italy call into question the continued viability of a widely-understood EMS policy of periodic realignment. Yet the speculative response of capital flows to expected parity change is an area that has received little attention in the academic literature. The relative neglect of the role parity changes play in balance of payments crises is puzzling: empirically, devaluation fears are a leading – perhaps the leading – factor behind currency flight, just as speculative inflows are often inspired by hopes of revaluation. A further shortcoming of the existing literature is that, for the most part, it stops short of analysing the possible real macroeconomic effects of exchange-rate crises.