Chapter

Appendix I. Interest Rate Convergence in Countries with a Currency Board Arrangement

Author(s):
Charles Enoch, and Tomás Baliño
Published Date:
September 1997
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One main benefit of a CBA is to facilitate the convergence of domestic interest rates to international levels. This appendix describes interest rate convergence processes in Argentina, the Baltic countries, and Hong Kong following the introduction of the CBA.

In Argentina immediately after the CBA was introduced, deposit rates, the interfirm market rate, and the money market rate fell sharply (Figures 10 and II).76 Long-term lending rates, however, were influenced by conditions of the banking system and domestic risk factors, as well as lending policy and strategies of financial institutions; therfore, they did not converge as rapidly to levels in the United States. Currency and country risks declined steadily, reflecting the CBA’s credibility. Currency risk, which may be inferred from the spread between interest rates on peso and U.S. dollar deposits, fell from around 5 percent in April 1993 to 1 percent in February 1994.77 Except for a small run at the end of 1992, the Argentine peso deposit rate converged to the U.S. deposit rate at a faster pace than did the Mexican peso deposit rate (Figure 10). Furthermore, the Argentine peso deposit rate increased less than similar rates in Mexico and returned much faster to its original level during the 1995 currency crisis. The spread between the U.S. dollar deposit rate in Argentina and a comparable deposit rate in the United States—which can be a proxy for country risk—also declined steadily after April 1993, but rebounded sharply in 1995 when banking sector problems added to the pressure on the currency (Figure 10). Similarly, the monetary market rate declined sharply after the CBA was introduced (Figure 11). Despite a temparory surge at the beginning of 1995, it almost converged to the U.S. federal funds rate later in the year.

Figure 10.Argentina, Mexico, and United States: Deposit Rates

(In percent a year)

Sources: IMF, International Financial Statistics; and IMF staff estimates.

Figure 11.Argentina: Money Market Rates

(In percent a year)

Source: IMF, International Financial Statistics.

In the Baltic countries, as Saavalainen (1995) has argued, the rapid decline in interest rates during the early reform period in Estonia, as compared with Latvia, appears to be mostly a result of the higher credibility of its CBA.78 In 1994 and 1995, the Estonian interbank rate deviated from the German inter-bank rate by less than 0.5 percent on average, and the spread between deposit rates in the two countries declined continuously (Figures 12 and 13). By contrast, the interbank rate in Latvia, despite its declining trend, was still at around 20 percent at the end of 1995.79 In Lithuania, the interbank rate also declined sharply after the CBA was adopted; however, it remained higher than in Estonia owing to problems in the Lithuanian banking system and persistent rumors of devaluation (Figure 12).80

Figure 12.Estonia, Germany, Latvia, Lithuania, and United States: Interbank Rates

(In percent a year)

Source: IMF, International Financial Statistics.

Figure 13.Estonia, Germany, Latvia, Lithuania, and United States: Deposit Rates

(In percent a year)

Source: IMF, International Financial Statistics.

The Hong Kong interbank offered rate (HIBOR) converged to the London interbank offered rate (LIBOR) quickly after the CBA was introduced. Since then, spreads between the two rates have been small except during 1985–87 when revaluation expectations prevailed (Figure 14). While the volatility of the HIBOR and the deposit rate was substantial, it was reduced after the Liquidity Adjustment Facility (LAF), a rediscount facility, was introduced in June 1992 and the HKMA adopted an interest rate targeting strategy in March 1994.81 Spreads between the rates for Hong Kong dollar and U.S. dollar transactions—both deposits and lending—also declined steadily over time.

Figure 14.Hong Kong and United States: Interest Rates

(In percent a year)

Sources: Hong Kong Monetary Authority; and IMF, International Financial Statistics.

1Hong Kong interbank offered rate.

2Liquidity Adjustment Facility.

3London interbank offered rate.

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