Exchange rate regime, real misalignment and currency crises

Based on 69 sample countries, this paper examines the effect of macroeconomic fundamentals on real effective exchange rates (REER) in these sample countries. Using the misalignment of actual REER from its equilibrium level, we have estimated the factors explaining the extent of currency over- or under-valuation. Overall, we find that the higher the flexibility of the currency regime, the lower is the misalignment. The estimates are robust to different sub-samples of countries. We then explore the impact of such misalignment on the probability of a currency crisis in the next period, indicating the extent to which misalignment could be used as a leading indicator of a potential crisis. This paper thus makes a new contribution to the debate on the choice of exchange rate regime by bringing together real exchange rate misalignment and currency crisis literature.