Exchange Rate Mean Reversion within a Target Zone: Evidence from a Country on the Periphery of the ERM

The aim of this study is to assess to what extent the Portuguese participation in the European Monetary System has been characterized by mean reverting behaviour, as predicted by the exchange rate target zone model developed by Krugman (1991). Although exchange rate mean reversion is widely referred to in the literature, only a small number of studies have been devoted to the analysis of its empirical validity. Most of this work has been based almost exclusively on standard Augmented Dickey-Fuller (ADF) unit root tests and focused especially on the most stable and credible bands, ignoring completely the currencies on the periphery of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). In our study we attempt to overcome this important insufficiency in the target zone literature.Based on the target zone model developed by Krugman (1991) we studied the stationarity of the Portuguese escudo against the Deutschmark in the context of the participation of the Portuguese currency in the ERM of the EMS. For this purpose, a new class of mean reversion tests is introduced, based not only on the traditional unit root and stationarity tests (ADF, KPSS, Perron and Lanne tests), but also on a set of variance-ratio tests. The aim with this second set of tests was to analyse the effects of a unit shock on the exchange rate series over time (Cochrane test). We also tried to ascertain whether the foreign exchange market could still work efficiently (Wright test) if there is no mean reversion. To accomplish this, we analysed the existence of a martingale difference sequence in the exchange rate series.The empirical analysis of mean reversion in the Portuguese exchange rate shows that most of the traditional unit root and stationarity tests point to the nonstationarity of the exchange rate within the band. However, using a set of variance-ratio tests, it was possible to detect the presence of a martingale difference sequence. This suggests that the Portuguese foreign exchange market has functioned efficiently, allowing us to conclude that the adoption of an exchange rate target zone regime has contributed decisively to the creation of the macroeconomic stability conditions necessary for the participation of Portugal in the euro area.