Real Exchange Rate Misalignment and Currency Crises

Abstract

This article calculates the real exchange rate misalignment (RERM) of the rupiah to examine the role of misalignment in exchange rate crises in Indonesia. The article does this by employing an autoregressive regime-switching model and behavioural equilibrium exchange rate (BEER) approach. The findings are as follows. First, net foreign assets and the relative productivity differential between sectors significantly influence the equilibrium exchange rate, indicating that external and internal balance determine the behaviour of the rupiah in the long run. Second, the BEER approach can properly predict misalignment of the rupiah, especially through explaining the overvaluation periods of the rupiah before the Asian financial crisis. The regime switching model performs well in identifying episodes of stability and volatility in the rupiah. Third, of the 17 crisis episodes experienced in Indonesia in 1981–2012, 10 were preceded by high RERM.