The Interest Rate-Exchange Rate Nexus in Currency Crises.(Statistical Data Included)

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Atish Ghosh (*)

One of the more controversial elements of the stabilization programs in the East Asian crisis countries (Indonesia, Korea, and Thailand) was the stance of monetary policy. With the sharp exchange rate depreciations experienced at the onset of the crisis, standard policy prescriptions called for an immediate tightening of monetary policy.

But continued depreciation of the exchange rates--well into the stabilization programs--began to raise doubts about the efficacy of raising interest rates to defend the currency. (1) Some commentators, indeed, started suggesting that raising interest rates, far from stabilizing the exchange rate, could actually prove counterproductive: further depreciating the exchange rate instead of appreciating it. The mechanism of this "perverse" effect is straightforward. High (presumably, real) interest rates, by causing widespread bankruptcies (or the expectation thereof), result in larger country risk premiums--so much so that the expected return to investors actually declines as interest rates increase, thus prompting even more capital flight and generating greater downward pressure on the exchange rate. (2)

Establishing whether tighter monetary policy--often taken to mean an increase in nominal interest rates--appreciates or depreciates the currency turns out to be a surprisingly difficult task. Such studies as do exist typically use regressions or vector autoregressions to correlate exchange rate movements to changes in nominal interest rates. This approach, however, runs into two main problems. (3)

First, the level of nominal interest rate is simply not a good measure of the monetary stance. To give but the starkest example, in January 1998 interest rates in Indonesia reached almost 60 percent per year (far higher than the interest rates witnessed in the other Asian crisis countries) at a time when the money supply was expanding at a monthly rate of 30 percent--scarcely a tight monetary stance. Second, simple time series correlations or vector autoregressions provide very little structure on the model, and their empirical performance in explaining exchange rate movements--even in the absence of a crisis--is, at best, limited. It is difficult to know what to make of a statement such as "higher interest rates are not correlated with exchange rate appreciations during the East Asian crisis" when the model is mute on what is driving the exchange rate.

In this paper, we propose an alternative approach to examining whether high real interest rates resulted in exchange rate depreciations. We start from the simple proposition that, as the relative price of two monies, the exchange rate should appreciate in response to a contraction of the domestic money supply. This, together with the empirical observation that in the Asian crisis countries there is a somewhat better correspondence between the exchange rate and the money supply (than between the exchange rate and interest rates), suggests that a standard monetary model may be useful for explaining the bulk of the exchange rate dynamics. This allows us to isolate the risk premium, controlling for changes in monetary policy, and permits a direct test of whether higher real interest rates are associated with a larger risk premium--and thus, ceteris paribus, downward pressure on the exchange rate.

By measuring the monetary stance by the money supply, and by using an explicit model of exchange rate determination, our approach goes at least part of the way in addressing the methodological problems identified above. Of course, even if higher real interest rates are correlated with a larger risk premium, it does not necessarily follow that tightening monetary policy is counterproductive for stabilizing the exchange rate. The magnitude of the effect on the risk premium may be small. And, of course, there may be third factors (such as adverse political news) affecting both the real interest rate and the risk premium on the exchange rate. Nonetheless, if the findings suggest no correlation between real interest rates and the risk premium, then the possibility of the perverse effect (of tight monetary policy causing an exchange rate depreciation) can be ruled out.

We apply our methodology to the 1997 currency crises in the three Asian countries and, by way of comparison, to the 1994 Mexican crisis. Our results may be summarized briefly. We find that the pure monetary model does credibly well in explaining much of the observed exchange rate movements (though the stringent cross-equation constraints are rejected). Augmenting this framework to allow for a time-varying risk premium, we find little evidence that high real interest rates are correlated with a larger risk premium in any of the countries except Korea. Once a simple contagion variable is added to the explanatory variables of the risk premium, moreover, the significance of the real interest rate diminishes even in the case of Korea. We conclude that there is little evidence of a "perverse" effect of a monetary tightening on the exchange rate.

The remainder of the paper is organized as follows. Section I provides a brief review of the literature and an overview of exchange rate developments during the crisis. Section II lays out the methodology. Section III reports the parameter estimates of the monetary model. Section IV turns to the behavior of the risk premium. Section V concludes.

I. Background

Perhaps the most dramatic aspect of the East Asian crisis was the sharp depreciation of exchange rates. Before the crisis, the nominal exchange rates in these countries had, to varying degrees, been de facto pegged against the U.S. dollar. In July 1997, the Thai baht depreciated by 18 percent, eventually going from baht 25 to baht 54 per U.S. dollar (at its most depreciated rate, in January 1998). The initial (sharp) depreciations in Indonesia and Korea were somewhat smaller, around 12 percent (in August 1997 and November 1997, respectively), though the maximum depreciations--from, 2,400 rupiah to 15,000 rupiah per U.S. dollar; and 850 won to 1,700 won per U.S. dollar (January 1998)--were, if anything, even more spectacular. (4)

Confronted by sharply depreciating exchange rates, monetary policy had to tread warily between two objectives. Under the assumption that tighter monetary policy would stabilize the exchange rate, there was an obvious need to limit the currency depreciation, not least because of the large foreign currency debt exposures of the banking and corporate sectors (particularly in Thailand and Indonesia). Against this was the danger of an excessive contraction that could severely weaken economic activity. In the event, this dilemma resulted in stop-go policies, with significant declines in money growth rates occurring only in early 1998 in Korea and Thailand. In Indonesia, a deepening banking sector crisis necessitated massive liquidity injections, and the money supply grew rapidly until mid-1998.

The continued exchange rate depreciations despite (generally) rising interest rates began to raise doubts about the efficacy of raising interest rates to defend the currency. On the other hand, at least to date, direct evidence that higher interest rates--brought about by raising risk premiums--resulted in further depreciation of the exchange rate (whether in East Asia or elsewhere) has been scant.

Furman and Stiglitz (1998) identify a set of 13 episodes, in nine emerging markets, of "temporarily high" interest rates. Using a simple regression analysis, they find that both the magnitude and the duration of such interest rate hikes are associated with exchange rate depreciation. Though they caution that …