Virtual and composite fundamentals in the ERM

A latent-variable approach is applied to identify the appropriate driving p rocess for fundamental exchange rates in the ERM. From the time-series char acteristics of so-called "virtual fundamentals" and "composite fundamentals ", a significant degree of mean reversion can be asserted. The relative deg ree of mean reversion across countries closely corresponds to often assumed degrees of economic integration vis-a-vis Germany as well as documented de grees of credibility of the exchange rate policies pursued. Convergence in fundamentals appears to be larger under the "new" EMS than in the previous years, but has again diminished after German unification and the subsequent widening of the ERM bands in 1993.