Ebook The Empirical Relationship Between Exchange Rates and Interest Rates in Post-Crisis Asia
The defacto peg to the US dollar of East Asia’s currencies and the attendant moral hazard problem have often been cited as important causes of the 1997 financial crisis that hit the region. In the aftermath of the crisis, all the crisis-hit countries (with the notable exception of Malaysia) announced a shift from exchange rate based monetary policy framework to the explicit adoption of inflation targeting. Notwithstanding continued official interventions in the foreign exchange markets, these countries, namely, Indonesia, (South) Korea, Philippines and Thailand announced their move towards using interest rates as the key monetary policy operating instrument. The experiences by these economies pose several interesting questions. For instance, do these countries employ the interest rate policy more actively to smooth exchange rate fluctuations in the post crisis period? Are their exchange rates now more responsive to international pressure than before? Does greater exchange rate flexibility help reduce interest rate volatility?
To examine these issues, we explore the empirical relationship between the exchange rate and interest rate in levels and variability for the four Asian crisis countries. The levels relationship between the interest rate and the exchange rate can at times be ambiguous. For instance, whether higher interest rates are an essential part of the defense strategy for the currency in times of financial crisis is controversial. This uncertainty is well borne out in the context of the Asian financial crisis. While many economists, including those from the IMF, recommended sharp increases in the interest rate to stem large depreciation of the currency, some including Furman and Stiglitz (1998) argue that the high interest rate policy destabilizes exchange rates by raising corporate bankruptcies and accelerating capital outflows.
With regard to the volatility relationship, it is conventionally argued that greater exchange rate variability is stabilizing in the sense that it releases the pressure off the economy and promotes stability in such macroeconomic aggregates as interest rates, money supply and output. Indeed, one of traditional advantages of floating rates is that interest rates are more stable as the monetary authority is free from the burden of maintaining the exchange rate fixed. (Reinhart and Reinhart, 2001) Conversely, fixing the exchange rate is considered to induce intersectoral or intertemporal shift in volatilities to other variables (Frenkel and Mussa 1980; Frankel and Rose 1995; Rose 1995). In this approach, the Asian financial crisis is cited as an example of such volatility shifts under fixed or tightly managed exchange rate regimes. On the other hand, the hypothesis that exchange rate volatility may enhance volatility in other variables such as interest rates has had many followers. (Nurkse 1944 and McKinnon 2001).
When considering the interaction between the interest rate and the exchange rate, it is necessary to control the influence of extraneous factors. In the context of East Asia, we consider three major sources of shocks to regional financial markets: the U.S. interest rate, the yen-dollar exchange rate, and the average dollar exchange rate of neighboring countries. First, the U.S. interest rate measured by the federal funds rate sets a basic point of reference in the financial markets that are closely linked to the U.S. Second, fluctuations in the yen-dollar exchange rate strongly affect East Asian economies. Indeed, the sharp depreciation of the yen that started in 1995 has been considered as one of important causes of the Asian financial crisis. Third, the average of the dollar exchange rates of other East Asian countries captures the effects of competition among East Asia countries. There is a consensus that contagion was an important source of the financial crisis and trade competition a key channel of contagion in East Asia. See, for instance, Baig and Goldfajn (1999) and Glick and Rose (1999).
In this paper, we apply the bivariate vector autoregression ? generalized autoregressive conditional heteroskedastic (VAR-GARCH) model to weekly data for each of the four Asian crisis economies for simultaneous estimation of the level and volatility relations between the exchange rate and interest rate, and determine whether these relationships have been altered following the crisis. To anticipate the main findings of the paper to the afore-mentioned questions: we found that exchange rate levels are more sensitive to competitors’ exchange rate after the crisis. However, we found no evidence to support the more active use of interest rate policy to stabilize exchange rate in the post-crisis period. The results also indicate that increased exchange rate flexibility do not affect interest rate volatility positively or negatively in these economies.
The rest of the article proceeds as follows: the next section contains a preliminary analysis of historical exchange rate and interest rate movements. Section 3 describes the econometric methodology used in empirically determining the relationship between exchange rates and interest rates. The empirical results are presented in Section 4. This paper ends in Section 5 with some concluding remarks.
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