In the past decades, world capital markets have experienced a large number of sovereign defaults, especially higher frequency in Latin American countries. These economies borrow from the rest of the world more and simultaneously increase the debt-to-GDP ratio so as to result in their sovereign default risk. If investors feared that a country, like Mexico in 1994–1995, would probably be unable to honor its commitments on its bonds coming due. This evidence made investors unwilling to buy new bonds which bear fair market interest rates because of its higher default risk. Unable to sell new bonds on a fair real rate, the government have to pay interest higher for its new financing. This not only raised the cost of new borrowing from abroad, but resulted in difficulties associated with rolling over the debt later on (Frankel and Rose [9]).
On the one hand, if a country accumulates a higher stock of foreign external debt, the risk premium should be raised for higher default risk. Rational investors will expect that the country will result in more capital outflow in the future for their payment, so that the real exchange rate will be expected to depreciate. On the other hand, a more depreciated real exchange rates and a higher stock of external debt liability will be associated with a lower propensity to devalue. An overvalued real exchange rate may temporarily bring some short-term benefits in the form of lower inflation and improved budgetary performance, but the long-run costs will be overwhelming. Faini and Gressani [8] argue that attempts at maintaining an overvalued exchange rate can be very short-lived and costly even in a country where a large stock of external debt liability raises the cost of devaluation.
The fluctuation of real exchange rates remains a substantial issue of empirical research in developing countries. Unfortunately, until quite recently, discussion of the topics still has largely incomplete because the typical investigation of real exchange rate fluctuations has been emphasized the examinations on developed economies, but less popular in emerging markets. More importantly, fewer study examines the real exchange rate behaviors for developing countries which experienced external debt problems ever in theoretical or in empirical. This paper attempts to identify additional sources of debt and exchange rate fluctuations and to clarify their interrelations in the past decades.
It is clear that real exchange rates have been substantially more volatile after the collapse of the Bretton Woods agreements. In a crucial paper, Eichenbaum and Evans [7] find that an orthogonalized shock to the monetary policy leads to persistent, significant appreciations in nominal and real exchange rates of the United States. Bergin [1], Lane [11]and Lee and Chinn [13] build a small open economy for empirically investigating the dynamics of real exchange rates and current accounts in developed countries. Additionally, Bergin [2] and Bouakez [4] account for U.S. real exchange rates changes based on two-country model. The empirical literature revels that some exchange rate volatilities are attributable to real shocks and that real exchange rates appear to possess a unit root (Huizinga [10]). Our investigation builds on the literature that attempts to explain the fundamental sources of real exchange rates and external debt liabilities.
We build a dynamic stochastic general equilibrium model of a small open economy with endogenized real interest rate to match the Mexican debt and exchange rate facts. We attempt to answer two questions in this paper. First, what are the main sources of real exchange rate volatility? Second, what are the interrelations between debt and exchange rate in Mexico ? To address these issues, we estimate the components in debt and exchange rate fluctuations using a multivariate version of the Cholesky decomposition. In addition to lagged both, the vector autoregression (hereafter, VAR) information set is used to forecast future adjustments including the ratio of the lagged supply and policy variables. This leads to empirically testable implications of both variables, and we investigate the patterns of their dynamics in response to different shocks. Our results shed some light on the real effect of nominal innovation.
We find that both dynamics in response to different macroeconomic innovations are consistent. A bidirectional causality runs between debt and exchange rate. Unfortunately, external debt liability does not really Granger-cause interest rate changes significantly in our examinations. An unit change in the supply and policy innovations are associated with a significant response in the debt and exchange rate. The peak changes in real exchange rates usually occur with 2 to 3 quarters delay with a size of 1 percent or less. Supply shocks and interest shocks often temporarily affect both external debts and real exchange rates. The plan of the paper is as follows. In order to illustrate the connection between innovations and both external debt and the real exchange rate, we construct a small open economy model in section 2. Section 3 presents the empirical methodology. Section 4 analyzes our results, and in section 5, we draw conclusions and make suggestions for future research.
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Debt Elastic Interest Rates and Real Exchange Rates
