This Selected Issues paper for Thailand highlights the effect of higher global interest rates on Thailand and the relationship between financial crises and long-term potential growth. Since the Asian crisis, Thailand has adopted an inflation targeting regime, and has intervened in the foreign exchange market to prevent excessive baht volatility. The monetary tightening in the United States in 1994 has been followed by heightened bond market volatility and a widening of emerging countries’ credit spreads.

Abstract

This Selected Issues paper for Thailand highlights the effect of higher global interest rates on Thailand and the relationship between financial crises and long-term potential growth. Since the Asian crisis, Thailand has adopted an inflation targeting regime, and has intervened in the foreign exchange market to prevent excessive baht volatility. The monetary tightening in the United States in 1994 has been followed by heightened bond market volatility and a widening of emerging countries’ credit spreads.

II. The role of Interest rates in Business Cycle Fluctuations in Emerging Countries: The Case of Thailand1

A. Introduction

Emerging economies have enjoyed an exceptionally favorable economic and financial environment throughout 2004 and early 2005, supported by solid global growth, low interest rates, and suppressed credit spreads. The United States’ easy-money policy of recent years has spilled worldwide, creating an environment of low interest rates in international markets. If world interest rates were to take a sudden course upward, this would increase the cost of borrowing for emerging economies, and lead to less hospitable financing conditions for emerging markets. The purpose of this chapter is to measure the effect of shocks to world interest rates on real activity in Thailand. The analysis employs the Global Economy Model (GEM) developed by the Research Department of the IMF.

1. The paper is organized as follows. Section B describes the importance of interest rates in determining business cycles in emerging market economies. Section C introduces the model and explains the calibration. Section D describes the effects of two sets of interest rate and credit spread shocks: a 1 percent interest rate blip in the United States on output, consumption, investment, labor effort, and capital stock in Thailand, and an experiment that resembles the global bond market rout of 1994. Section E investigates how monetary policy can best minimize the impact of a more prolonged interest rate hike in the United States combined with a higher risk premium in Thailand.

B. Interest Rates and Business Cycles

2. Interest rates are a key determinant of business cycles in emerging markets. In recent years, a great number of emerging economies have coped with frequent and large changes in the interest rates that they face in international financial markets; these changes have usually been associated with significant business cycles swings. This observation is illustrated in the figure below, which graphs output and country interest rates for six emerging market economies. Periods of low interest rates are typically coupled with economic expansion, and times of high interest rates are often associated with suppressed levels of aggregate activity.

uA02fig01

Real Interest Rates and Real Output in Selected Emerging Market Countries

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

Sources: IFS; Emerging Market Bond Index (EMBI) Global Spread; and Fund staff calculations.Note: Output is seasonally adjusted real GDP, and is detrended using the HP filter. Interest rate is constructed as the sum of the 90-day U.S. T-bill and the J. P. Morgan EMBI Global Spread for the respective country, adjusted for the United States’s expected inflation.

3. The link between interest rates and output in emerging countries is markedly different from that in developed economies. While the previous figure demonstrates that real interest rates in emerging markets are clearly countercyclical, in the developed countries the interest rates are at best acyclical. The following figure depicts this relationship for four small open economy developed countries.

uA02fig02

Real Interest Rates and Real Output in Selected Developed Economies

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

This is further demonstrated by the estimates for the correlation coefficients for these countries, shown in the table.

Correlation of Real Interest Rates with GDP

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Source: Fund staff calculations.

In addition, real interest rates in emerging economies lead the cycle, whereas in developed economies interest rates lag the cycle. This point is illustrated in the next figure, which shows the cross correlations between GDP and real interest rates in emerging and developed countries. In all emerging countries, there is a distinctive U-shaped pattern of the cross correlation, whereas in developed countries the cross correlations are completely different and do not exhibit this pattern.

uA02fig03

Correlation Between Real Interest Rates and Real Output in Emerging and Developed Countries

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

C. The Global Economy Model with the Financial Accelerator

4. GEM2 is a new type of policy model with strong microeconomic foundations, in which consumers maximize utility and firms their profits. MULTIMOD was the policy model of choice in the IMF in the last two decades. While MULTIMOD is able to generate realistic dynamic responses to cyclical disturbances, its lack of solid theoretical foundations makes it susceptible to the “Lucas critique.” In particular, policy analysis using reduced-form equations that fit the data but are only loosely tied to theory, can not properly account for resulting shifts in behavior. GEM, on the other side, combines production, consumption, nominal rigidities, trade, and international financial markets in a coherent theoretical framework.

5. GEM has many important strengths. First, GEM can study policies in a general equilibrium setting, thus taking into account the full range of interactions between consumers and producers as well as across sectors and countries. Second, the costs and benefits of a policy can be measured by the impact on consumer welfare, rather than by using less accurate and more ad hoc proxies of welfare. Third, GEM has a very flexible structure, so that one can include or exclude features easily in accordance with the issue at hand.

6. However, moving to a model with tight theoretical structure imposes some limitations. First, models are not easy to build and run. Second, the need to create a large interlinked structure constrains theoretical specifications and hence model properties.3 Third, calibration is time-consuming, as the model concepts do not dovetail with existing data.4 Fourth, capital account is not richly modeled and, therefore, issues related to capital flows can not be adequately addressed.

7. The following figure displays the simplest version of a two-country GEM structure.5 Labor and capital are combined to produce a single type of tradable good that can be used for consumption or investment. Given the preferences of consumers, firms, and the government, these goods are then distributed across countries.

uA02fig04

Simple GEM Structure

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

8. A key feature of the model is that it breaks down the domestic interest rate into the sum of world interest rate and country risk premium, and that it endogenizes the premium. Shocks to world interest rates do not usually translate one to one to movements in country interest rates due to the presence of country risk premia. They themselves may be positively related to world interest rates, and may, therefore, amplify the interest rate cycle of industrial countries.6 The attempt to analyze the relationship between interest rate and real activity is also complicated by the fact that country risk premia respond systematically and countercyclically to business conditions in emerging economies.7 The model endogenizes the risk premium by assuming that it moves inversely with the net worth, so that it becomes increasingly difficult to borrow when the country faces unfavorable shocks.8

9. This is captured in the model through the financial accelerator mechanism. The financial accelerator mechanism refers to the combination of two salient features of economic environment in emerging markets that complicate the conduct of monetary policy. First, emerging economies typically can only borrow in foreign currency denominations, a phenomenon usually referred to as the “Original Sin.”9 Second, they are subject to a risk premium above and beyond the international lending rate. The risk premium depends on the economic conditions in the country. In particular, the premium is a positive function of the ratio of the value of assets to the value of net worth.

10. The financial accelerator mechanism amplifies the effects of shocks to world interest rate on the domestic economy. Since domestic interest rate is the sum of foreign interest rate and risk premium, interest rate hikes in the foreign country induce interest rate increases in the domestic economy. Due to nominal rigidities, this also leads to a rise in the real domestic interest rate which, in turn, engenders contraction in consumption, investment, and output. However, the fall in asset prices generated by the drop in output raises the ratio of value of assets to the value of net worth. As the risk premium is positively related to this ratio, the resulting increase in the risk premium further suppresses real activity beyond the original impact of the foreign interest rate hike.

11. The long-run properties of the model are calibrated to Thailand, the United States, and the Rest of the World (RoW). The table below provides a summary of the key steady state ratios calibrated using 2004 annual data. Sizes are based on a simple average of the shares of these countries in world population and GDP. Thailand makes up 1 percent, the United States 19 percent, and RoW 80 percent of the world. Consumption- and investment-to-GDP ratios for Thailand and the United States are calculated from national accounts data. Since the precise computation of these ratios for the RoW would require aggregating all individual countries’ consumption and investment data, it is simply assumed that consumption and investment in the RoW account for two-thirds and one-third of output, respectively. The imports-to-GDP ratio is significant in Thailand, amounting to 57 percent of GDP. The share of goods imported from the United States is 5 percent of GDP, and the rest of the goods are imported from the RoW. The United States is a much less open economy with imports-to-GDP ratio of 12 percent of GDP. The imports from Thailand are negligible, with the bulk of imports coming from the RoW. The RoW is almost a closed economy with imports-to-GDP ratio of 4 percent of GDP. Imports from the United States and Thailand account for 3.6 and 0.4 percent of GDP, respectively. The risk premium is calibrated using the EMBI index for Thailand. The risk premium has been steadily decreasing since the Asian crisis, and its average value in 2004 was 70 basis points.

Model Calibration

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Sources: IFS; BOT; and Fund staff calculations.

12. The deep parameters in the micro-founded model are calibrated using estimates from microeconomic studies. The deep parameters define the long-term responses of firms and consumers, such as the elasticity of substitution of different types of goods, and the responsiveness of hours worked to changes on real wages and of consumption to movements in real interest rates. Currently, the only available GEM calibration to an emerging market economy is the Czech Republic and this calibration is used in the exercise.10

13. The monetary framework in Thailand is based on inflation targeting. Since the Asian crisis, Thailand has adopted an inflation targeting regime, and has intervened in the foreign exchange market to prevent excessive baht volatility. The model assumes that monetary policy in Thailand is conducted by a Taylor rule. This rule is augmented with a target for the real exchange rate for the simulation with a managed float. This is a modeling assumption and does not imply that BOT actually targets the real exchange rate. The weight on the exchange rate is smaller than the weights on expected inflation and the output gap. Monetary policy for the United States and Row follows a Taylor rule with no weight on the real exchange rate.

D. Interest Rate and Credit Spread Shocks

14. A 1 percent interest rate shock in the United States moderately suppresses economic activity in Thailand. It is assumed that half of the increase in the foreign interest rate is transmitted to the domestic interest rate. The impulse response functions on the next page depict the dynamic behavior of the economy, and show that the largest decrease in the main economic variables occurs 4–5 quarters after the shock. GDP, consumption, investment, and labor effort drop by 0.19, 0.04, 0.57, 0.23 percent relative to steady state, respectively. Due to the presence of adjustment costs, capital accumulation reaches a trough of minus 0.08 percent relative to steady state 10 quarters after the shock. Since the risk premium is calibrated only at 70 basis points in steady state, it is only negligibly affected by the foreign interest rate shock. Entrepreneurs’ net worth is reduced by 0.7 percent. percent.11

15. The cumulative costs to the interest rate hike are also limited. The table computes the cumulative output, consumption, investment and capital losses in Thailand and the United States of a 1 percent interest rate blip in the United States.

Cumulative Losses in Thailand and the United States from a 1 Percent Interest Rate Hike in the United States

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uA02fig05

Impulse Response Functions to 1 Percent Interest Rate Shock in the United States

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

Source: Fund staff calculations. Note: Impulse response functions in Thailand to a 1 percent interest rate blip in the United States. The impulse response functions are computed as percent deviations from the steady state.

16. The monetary tightening in the United States in 1994 was followed by heightened bond market volatility and widening of emerging countries’ credit spreads. The Federal Reserve Board (Fed) began tightening monetary policy in February 1994. During the following 12 months, the Fed rate was doubled to 6 percent in the course of seven successive rate increases. Bond market volatility and the 10-year U.S. treasury yields shot up by 250 basis points, peaking at 8 percent in November 1994. In the process, investors curtailed their borrowing at short-term rates and their exposure to longer-dated, higher-yielding securities. This resulted in a marked widening of emerging bond market yield spreads from 405 basis points at end-1993 to 800 basis points in mid-December 1994.

17. Current benign global market conditions for emerging economies are reminiscent of the period preceding the sell-off of 1994. Low interest rates in the major financial centers, improved fundamentals, and abundant liquidity buoyed global asset prices. The complementary benefit of better credit quality pushed credit spreads on emerging market bonds to low levels. These factors created a very favorable external environment for emerging market borrowers in 2003 and 2004—with the EMBIG composite declining from 728 basis points at end-2002 to 423 basis points at end-2004—despite the onset of monetary policy tightening in the United States, significant commodity price volatility, and further widening of global imbalances.

18. Nevertheless, the risks that did not materialize in 2004 remain a concern. Government bond yields and credit spreads remain quite low, leaving little room for unanticipated spikes in world interest rates. An unanticipated spike in yields and volatility in the U.S. treasury market could trigger a widening of credit spreads on emerging market bonds. Emerging market borrowers would face higher borrowing costs, and underlying vulnerabilities that have been masked by the very favorable external financing environment.

19. A recent IMF study found that mature market interest rates and global liquidity have become the most important determinants of emerging market spreads following September 2001. The IMF’s 2004 Global Financial Stability Report estimates a simple econometric model with a view to identifying the drivers of the latest emerging bond market rally. Theoretical predictions suggested that the model should include relevant measures of country-specific fundamentals, global liquidity as represented by mature market interest rates, the expansion of demand through the widening investor base, and risk preferences. The main conclusions are that these variables are significant and that the signs are as expected, with improved fundamentals, greater investor demand, and lower volatility all lowering spreads. However, while improving fundamentals are found to have been a significant factor driving the contraction of emerging bond market spreads, the estimation results indicate that liquidity stemming from the U.S. interest rate easing cycle has become a more important influence than fundamentals in the emerging bond market rally.

20. Two percent interest rate shock in the United States over four quarters and a risk premium of 7 percent could have serious economic consequences for Thailand. It is believed that the Fed will continue to raise the short-term rate to a “neutral” level that should minimize inflationary pressures but not dampen economic growth. Various estimates suggest that the “neutral” level is somewhere between 3 and 5 percent. It is assumed that the interest rate in the United States will be raised by 2 percent in four 50-point increments over a year. The average emerging market spread since 1990 to 2004 is about 7 percent, and the risk premium is calibrated at this level. The graphs show the response of key economic variables in Thailand to a 2 percent shock in the United States with and without the financial accelerator mechanism.

uA02fig06

Impulse Response Functions to 2 percent Interest Rate Shock in the United States

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

Source: Fund staff calculations.Note: Impulse response functions in Thailand to a 2 percent interest rate shock in the United States lasting for four quarters. The impulse response functions are computed as percent deviations from the steady state.

21. The cumulative costs to the interest rate hike are also significant. The table computes the cumulative output, consumption, investment and capital losses in Thailand following a 2 percent interest rate shock in the United States lasting for one year. In the model without the financial accelerator output, consumption, investment and capital decrease by 1.80, 2.31, 1.75 and 2.60 percent, respectively. The presence of the financial accelerator adds considerably to the losses, with output and consumption falling by 2.90 and 3.09 percent. The losses are much larger in investment and capital, which drop by 8.10 and 8.08 percent. This is explained by the fact that the financial accelerator operates mainly through the investment channel. As investment projects are financed by net worth and foreign debt, and the risk premium depends negatively on the capital-to-net worth ratio, an increase in the foreign interest rate reduces asset prices in Thailand and, therefore, pushes up this ratio. The associated rise in the risk premium makes foreign financing less accessible and chokes investment and capital accumulation. This has repercussions for output.

Cumulative Losses in Thailand from a 2 Percent Interest Rate Hike in the United States

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E. What Role for Monetary Policy?

22. The final experiment investigates what exchange rate regime can best limit the impact of spillovers from higher U.S. interest rates. The last table underscores the severity of the economic losses that could face Thailand. The obvious question is to what extent monetary policy can affect these losses. It is assumed that monetary authorities in Thailand can pursue three different exchange rate regimes via a Taylor-type interest rate rule. A flexible exchange rate policy will target only inflation and the output gap. A fixed exchange rate policy will target the baht/dollar exchange rate. A regime of managed float implies that monetary authorities target simultaneously inflation, output gap, and the exchange rate, but the weight on the exchange rate is smaller than on inflation and the output gap

23. Thailand will minimize the effects of higher U.S. interest rates if it follows a flexible exchange rate policy. The impulse response functions and the computed cumulative output losses indicate that the economic losses will be minimized under a flexible exchange rate regime. The intuition is straightforward. The losses are biggest with the fixed regime as domestic interest rates will have to rise one-for-one with foreign interest rates. The fall in asset prices and, therefore, the rise in the risk premium are the largest under this scenario. The associated reduction in investment and capital accumulation contributes to the biggest output drop. In the case of a flexible exchange rate regime, the rise in the risk premium and the fall of output are the smallest. The managed float is an intermediate case.

uA02fig07

Impulse Response Functions under Three Different Exchange Rate Regimes

Citation: IMF Staff Country Reports 2006, 019; 10.5089/9781451836837.002.A002

Source: Fund staff calculations. Note: Impulse response functions in Thailand to a 2 percent interest rate shock in the United States computed in four 50-point increments. Impulse response functions are calculated for three exchange rate policies: flexible, managed float, and fixed. And are computed as percent deviations from the steady state.

Cumulative Losses in Thailand Under Three Different Exchange Rate Regimes

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ANNEX A Brief Note on the Gem

A. Overview

1. The IMF Research Department’s GEM is a large multi-country macroeconomic model, derived from a choice-theoretic basis, designed to analyze a range of policy issues. Building on recent research in international finance and monetary economics and following recent models in “New Open-Economy Macroeconomics” literature, GEM provides a general equilibrium stochastic framework for policy analysis. In particular, the model can be used to analyze policy questions such as the impact of structural reforms and the international transmission of shocks in the context of macroeconomic interdependence among countries. Among others, GEM has the following main features:

  • Imperfect competition (monopoly power) in product markets, for both tradables and nontradables;

  • Nominal wage and price rigidities, with wages and nominal prices of tradables and nontradables subject to adjustment costs, both for levels and rates of change;

  • Realistic hump-shaped responses of macroeconomic variables to shocks due to habit persistence in consumption and adjustment costs in capital accumulation and imports.

2. A three-country version of GEM is used in this paper. The three blocks are: Thailand, the United States, and the ROW. In each block, there are households, firms, and a government. Households maximize utility derived from the consumption of goods and leisure. Firms use capital and labor to maximize their net incomes from the production of nontradable and tradable intermediate goods and produce final goods. Governments consume goods financed through nondistortionary taxes and adjust short-term nominal interest rates to provide nominal anchors.

B. The Model Structure

3. Households own domestic retail firms, supply differentiated labor inputs to firms, and consume the final good. Households’ monopoly power in labor supply implies that the wages they receive contain a markup over the marginal rate of substitution between consumption and leisure. In addition, aggregate nominal rigidities materialize through the wage bargaining process due to adjustment costs in wage contracts. The market for capital is competitive, with accumulation subject to adjustment costs that also contribute to the gradual pace of adjustment of macroeconomic variables. Both labor and physical capital are immobile internationally. Households trade internationally short-term nominal bonds, denominated in U.S. dollars; there are intermediation costs for households entering the bond market.

4. There are three types of firms in the model—final goods producers, intermediate goods producers, and entrepreneurs. The final consumption and investment goods are produced in a perfectly competitive market. Firms use nontradable and tradable intermediate goods (domestic and/or imported) as inputs in final goods production. The final good is either used for investment by the entrepreneurs or consumed by domestic households or the government. The intermediate goods are produced in a monopolistically competitive market—as a result prices contain a markup over marginal cost. International trade is driven by the interaction of preferences, technology, and relative prices, as the structure of final good production reflects the preferences of households’ demand for, and firms’ production technology of, intermediate goods. Firms also provide financial intermediation services, enabling households to trade in bonds. The entrepreneurs manage the production process by deciding how much capital will be used in the production of intermediate goods. They can finance the acquisition of capital either by their net worth or by borrowing from abroad. Due to the presence of market imperfections in the capital markets, entrepreneurs’ demand for capital depends on their respective financial position—this is the key aspect of the financial accelerator. The model assumes the existence of an agency problem that makes uncollateralized external finance more expensive than internal funds. In addition, the agency problem defines exactly the form of the external finance premium, which depends on the ratio of capital to net worth. In general, the finance premium varies inversely with the entrepreneurs’ net worth—the greater the share of capital that the entrepreneurs can either self-finance or finance with collateralized debt, the smaller the agency costs and, hence, the smaller the external premium that they have to pay.

5. Governments use interest rates as nominal anchors and spend exclusively on final nontradable goods. Government spending is financed through a nondistorting consumption tax. The governments in all three regions control their national short-term nominal interest rates with the goal of providing a nominal anchor and price stability for their economies.

6. The parameter values of GEM used in this paper are calibrated by taking into account the following factors: empirical estimates available in the literature; the desired steady-state characteristics of the economies; and the model’s dynamic adjustment properties.12 While the focus has been primarily on the steady-state characterization of the economies, attention was also given also to achieving plausible dynamic adjustment responses for some key variables.

References

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1

Prepared by Ivan Tchakarov.

2

A brief note on the GEM is provided in the appendix.

3

For example, since the model is based on a single representative consumer, it can not be used to address issues of income distribution.

4

For example, it is not easy to split output into traded and nontraded goods or to determine the role of commodities and semifinished goods in production.

5

For a full technical description of GEM, see Laxton and Pesenti (2003).

6

Evidence in support of this notion can be found in Fernandez-Arias (1996), Kaminsky and Schmukler (2002), and Uribe and Yue (2003).

8

This uses the concept of the financial accelerator developed by Bernanke, Gertler, and Gilchrist (1999).

11

The assumption that half of the increase in the foreign interest rate is transmitted to the domestic interest rate may overstate the impact of US monetary policy on Thai monetary policy under the inflation targeting framework with floating exchange rate system.

12

To enhance the data coherence of the model’s parameter values, the IMF’s Research Department is working on Bayesian methods to estimate GEM parameters, extending the approach applied in Smets and Wouters (2003), and Del Negro and Schorfheide (2004). A smaller model with the financial accelerator has been estimated by Elekdag, Justiniano, and Tchakarov (2005).

Thailand: Selected Issues
Author: International Monetary Fund
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    Real Interest Rates and Real Output in Selected Emerging Market Countries

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    Real Interest Rates and Real Output in Selected Developed Economies

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    Correlation Between Real Interest Rates and Real Output in Emerging and Developed Countries

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    Simple GEM Structure

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    Impulse Response Functions to 1 Percent Interest Rate Shock in the United States

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    Impulse Response Functions to 2 percent Interest Rate Shock in the United States

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    Impulse Response Functions under Three Different Exchange Rate Regimes