During the past decade or so economists have emphasized the critical role that interest rate policies play in the development process. The growing literature on financial “reforms” and financial “liberalization” in developing countries has dealt with a variety of issues, such as the relation between financial intermediation and economic growth, the sensitivity of the volume of savings to changes in real interest rates, and the relation between investment and interest rates. Generally speaking, the empirical evidence indicates that there is indeed a positive association between the degree of development of the financial sector, including in particular freer interest rates, and economic performance in developing countries.1 This finding has undoubtedly prompted the authorities in a number of such countries to pursue policies to remove controls on interest rates and to allow market forces to play a relatively greater role in the determination of interest rates.
Now that the process of financial liberalization is well under way, however, economists and policymakers are faced with a different set of issues relating to interest rates in developing countries. The focus has begun to shift away from investigating the effects of freeing interest rates to examining how interest rates are in fact determined once the domestic financial market has been liberalized. The interest in this particular issue has been heightened by two factors. The first is the recent experiences of the countries of the Southern Cone of Latin America—Argentina, Chile, and Uruguay—where domestic interest rates rose to extraordinarily high levels following the implementation of financial reform policies.2 The second is the evidence that has accumulated suggesting that the high and volatile world interest rates in recent years were at least partially transmitted into developing countries. Both these factors have been a cause of concern to policymakers and have generated some fundamental questions about the behavior of interest rates in developing countries—in particular, about what should be expected when controls on interest rates are eliminated. At present, however, there are few studies dealing with this general issue, and even fewer specifically examining the respective influences of foreign factors and domestic monetary conditions as they affect interest rates in developing countries.3
It is obvious that the process of determination of interest rates will be significantly different under alternative degrees of openness of the capital account of the balance of payments. For example, in the case of a fully open capital account some form of interest arbitrage will hold, with domestic interest rates depending on world interest rates, expected devaluation, and perhaps some risk factors. In contrast, in countries with a completely closed economy (closed capital and current accounts) open economy factors will obviously play no role, and the nominal interest rate will be determined by conditions prevailing in the domestic money market and by expected inflation. Most developing countries, however, do not fall in either of these two extreme categories, so that interest rates will in general depend on domestic money market conditions, as well as on the expected rate of devaluation and world interest rates.4 From a policy perspective it is important to determine the way in which these different factors actually affect interest rates. For example, how expected devaluations or changes in domestic monetary conditions or both affect interest rates in developing countries is crucial for assessing the significance of one of the possible mechanisms through which stabilization policies will affect aggregate demand. Stabilization programs typically involve both exchange rate adjustments and tighter credit and monetary policies. If these policies generate an increase in the domestic (real) interest rate, there will be an additional channel (usually not considered in formal studies about stabilization programs in developing countries) through which aggregate demand will be affected.5
In this paper a framework is proposed for empirically analyzing the determination of nominal interest rates in developing countries. Even though the model is quite general and of relevance for any small country, the discussion is carried out with those developing countries in mind that have liberalized their domestic financial sectors in the sense that controls on interest rates have been removed. The model, which is described in Section I, combines features of models for both closed and open economies, and it is shown that the relative importance of the domestic monetary conditions and the open economy factors will depend essentially on the openness of the capital account. An interesting property of the model is that the approximate degree of openness of the financial sector in a particular country can be estimated from the data. In Section II of the paper the usefulness of this framework for analyzing interest rate behavior is illustrated using data for Colombia and Singapore. The results obtained indicate that, as expected, in Singapore only open economy factors appear to matter; in Colombia, however, both domestic monetary disequilibria and open economy conditions have influenced nominal interest rates during the past 15 years. Section III describes some areas in which the analysis could be extended—including, for example, studying the behavior of real interest rates, the determination of interest rates under changing degrees of openness, the modeling of the effects of expected exchange rate changes, and, finally, introducing the possibility of currency substitution. The concluding section summarizes the main points and results of the analysis.
APPENDIX: Data Sources and Definitions
This Appendix briefly gives the major sources of the country data and defines the principal variables used in the model.
Blanco, Herminio, and Peter M. Garber, “Recurrent Devaluation and Speculative Attacks on the Mexican Peso” (unpublished; Rochester, New York: University of Rochester, December 1983).
Blejer, Mario I., “Interest Rate Differentials and Exchange Risk: Recent Argentine Experience,” Staff Papers, International Monetary Fund (Washington), Vol. 29 (June 1982), pp. 270–80.
Blejer, Mario I., and Mohsin S. Khan, “The Foreign Exchange Market in a Highly Open Developing Economy: The Case of Singapore,” Journal of Development Economics (Amsterdam), Vol. 12 (February-April 1983), pp. 237–49.
Blejer, Mario I., and José Gil Diaz, “On the Determination of the Real Interest Rate in a Small Open Economy: Domestic Versus External Factors” (unpublished; Washington: International Monetary Fund, 1985).
Cumby, Robert E., and Maurice Obstfeld, “A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis,” Journal of Finance (New York), Vol. 36 (June 1981), pp. 697–703.
Cumby, Robert E., and Frederic S. Mishkin, “The International Linkage of Real Interest Rates: The European-U.S. Connection” (unpublished; New York: New York University, 1984).
Darby, Michael R., “The Financial and Tax Effects of Monetary Policy on Interest Rates,” Economic Inquiry (Long Beach, California), Vol. 13 (June 1975), pp. 266–76.
Diaz-Alejandro, Carlos F., “Southern-Cone Stabilization Plans,” in Economic Stabilization in Developing Countries, ed. by William R. Cline and Sidney Weintraub (Washington: Brookings Institution, 1981), pp. 119–41.
Dornbusch, Rudiger (1982a), “PPP Exchange-Rate Rules and Macroeconomic Stability,” Journal of Political Economy (Chicago), Vol. 90 (February), pp. 158–65.
Dornbusch, Rudiger (1982b), “Stabilization Policies in Developing Countries: What Have We Learned?” World Development (Oxford, England), Vol. 10 (September), pp. 701–08.
Edwards, Sebastian (1985a), “Money, the Rate of Devaluation, and Interest Rates in a Semi-Open Economy: Colombia, 1968-1982,” Journal of Money, Credit and Banking (Columbus, Ohio), Vol. 17 (February), pp. 59–68.
Edwards, Sebastian (1985b), “Stabilization with Liberalization: An Evaluation of Ten Years of Chile’s Experiment with Free-Market Policies, 1973-1983,” Economic Development and Cultural Change (Chicago), Vol. 32 (January), pp. 223–54.
Fama, Eugene F., “Short-Term Interest Rates as Predictors of Inflation,” American Economic Review (Nashville, Tennessee), Vol. 65 (June 1975), pp. 269–82.
Frenkel, Jacob A., and Richard M. Levich, “Covered Interest Arbitrage: Un-exploited Profits?” Journal of Political Economy (Chicago), Vol. 83 (April 1975), pp. 325–38.
Frenkel, Jacob A., and Richard M. Levich, “Transactions Costs and Interest Arbitrage: Tranquil Versus Turbulent Periods,” Journal of Political Economy (Chicago), Vol. 85 (December 1977), pp. 1209–26.
Fry, Maxwell J., “Models of Financially Repressed Developing Economies” World Development (Oxford, England), Vol. 10 (September 1982), pp. 731–50.
Hanson, James A., and Jaime de Melo, “External Shocks, Financial Reforms, and Stabilization Attempts in Uruguay: 1974-1983,” World Development (Oxford, England), Vol. 13 (forthcoming, August 1985).
Harberger, Arnold C., “The Chilean Economy in the 1970s: Crisis, Stabilization, Liberalization, Reform,” in Economic Policy in a World of Change, ed. by Karl Brunner and Allan M. Meltzer, Carnegie-Rochester Conference Series on Public Policy, Vol. 17 (Amsterdam: North-Holland, 1982; New York: Elsevier, 1982), pp. 115–52.
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)| false Harberger, Arnold C., “The Chilean Economy in the 1970s: Crisis, Stabilization, Liberalization, Reform,”in Economic Policy in a World of Change, ed. by Carnegie-Rochester Conference Series on Public Policy, Karl Brunnerand Allan M. Meltzer, Vol. 17( Amsterdam: North-Holland, 1982; New York: Elsevier, 1982), pp. 115– 52.
Khan, Mohsin S., “The Dynamics of Money Demand and Monetary Policy in Singapore,” in Monetary Authority of Singapore, Papers on Monetary Economics (Singapore: Singapore University Press for the MAS, 1981), pp. 46–76.
Lanyi, Anthony, and Rüşdü Saracoglu, “The Importance of Interest Rates in Developing Economies,” Finance & Development (Washington), Vol. 20 (June 1983), pp. 20–23.
Levich, Richard M., “Empirical Studies of Exchange Rates: Price Behavior, Rate Determination and Market Efficiency,” in Handbook of International Economics, ed. by Ronald W. Jones and Peter B. Kenen (Amsterdam: North-Holland, 1985; New York: Elsevier, 1985), pp. 979–1040.
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)| false Levich, Richard M., “Empirical Studies of Exchange Rates: Price Behavior, Rate Determination and Market Efficiency,”in Handbook of International Economics, ed. by ( Ronald W. Jonesand Peter B. Kenen Amsterdam: North-Holland, 1985; New York: Elsevier, 1985), pp. 979– 1040.
Lizondo, José Saul, “Interest Differential and Covered Arbitrage,” in Financial Policies and the World Capital Market: The Problems of Latin American Countries, ed. by Pedro Aspe Armella, Rudiger Dornbusch, and Maurice Obstfeld (Chicago: University of Chicago Press, 1983), pp. 221–40.
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)| false Lizondo, José Saul, “Interest Differential and Covered Arbitrage,”in Financial Policies and the World Capital Market: The Problems of Latin American Countries, ed. by ( Pedro Aspe Armella, Rudiger Dornbusch, and Maurice Obstfeld Chicago: University of Chicago Press, 1983), pp. 221– 40.
Makin, John H., “Effects of Inflation Control Programs on Expected Real Interest Rates,” Staff Papers, International Monetary Fund (Washington), Vol. 29 (June 1982), pp. 204–32.
Mathieson, Donald J., “Inflation, Interest Rates, and the Balance of Payments During a Financial Reform: The Case of Argentina,” World Development (Oxford, England), Vol. 10 (September 1982), pp. 813–28.
Mathieson, Donald J., “Estimating Models of Financial Market Behavior During Periods of Extensive Structural Reform: The Experience of Chile,” Staff Papers, International Monetary Fund (Washington), Vol. 30 (June 1983), pp. 350–93.
Melvin, Michael, “The Vanishing Liquidity Effect of Money on Interest Rates: Analysis and Implications for Policy,” Economic Inquiry (Long Beach, California), Vol. 21 (April 1983), pp. 188–202.
Montes, Gabriel, and Ricardo Candelo, “El enfoque monetario de la balanza de pagos: El caso de Colombia, 1968-1980,” Revista de Planeación y Desarrollo (Bogotá), Vol. 14 (May-August 1982), pp. 11–40.
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Ramirez-Rojas, C. Luis, “Currency Substitution in Argentina, Mexico, and Uruguay” (unpublished; Washington: International Monetary Fund, 1985).
Sjaastad, Larry A., “Failure of Economic Liberalism in the Cone of Latin America,” World Economy (Oxford, England), Vol. 6 (March 1983), pp. 5–26.
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Townsend, Robert M., “Financial Structure and Economic Activity,” American Economic Review (Nashville, Tennessee), Vol. 73 (December 1983), pp. 895–911.
van Wijnbergen, Sweder, “Interest Rate Management in LDCs,” Journal of Monetary Economics (Amsterdam), Vol. 12 (September 1983), pp. 433–52.
Wiesner, Eduardo, “Devaluación y mecanismo de ajuste en Colombia,” in Política económica externa Colombiana, ed. by Eduardo Wiesner (Bogotá: Asociación Bancaria de Colombia, 1978).
Zahler, Roberto, “Recent Southern Cone Liberalization Reforms and Stabilization Policies: The Chilean Case, 1974-1982,” Journal of Interamerican Studies and World Affairs (Beverly Hills, California), Vol. 25 (November 1983), pp. 509–62.
Professor Edwards was a consultant with the Research Department when this paper was written. He is currently with the University of California, Los Angeles, and with the National Bureau of Economic Research. He is a graduate of the Universidad Católica de Chile and of the University of Chicago.
Mr. Khan, Advisor in the Research Department, is a graduate of Columbia University and of the London School of Economics and Political Science.
The only studies we are aware of that include both open economy and domestic monetary factors in the analysis of interest rates are Mathieson (1982, 1983), on Argentina and Chile respectively; Blejer and Gil Diaz (1985) and Hanson and de Melo (1985) on Uruguay; and Edwards (1985a) on Colombia.
Even if the capital account of the balance of payments is closed but there is some trade with the rest of the world, open economy factors can still indirectly affect domestic interest rates. For example, a terms of trade shock can produce changes in real income and prices that will affect the domestic demand for credit and, thus, equilibrium interest rates.
Until now most studies that have analyzed the effect of stabilization policies on output, prices, and the balance of payments in developing countries have not included the interest rate as a possible transmission mechanism. The main reason for this omission is that the experience with liberalized capital markets is still relatively recent. A theoretical discussion, however, of the effects of a stabilization program working through increases in real interest rates is contained in Dornbusch (1982b).
Note that EMSt could also affect
In this formulation the weights of the lag distribution are not assumed to follow any specific pattern.
These would be the empirical representations of the rational expectations model in which economic agents are assumed to take into account all available information in forming their (conditional) expectations.
Note that equation (4) is only one of the alternative ways to specify excess money supply, or monetary disequilibrium. For example, it can be postulated that only money surprises will influence the real interest rate (Makin (1982)). In such a case EMS would have to be replaced by some proxy of unanticipated monetary changes in equation (2).
Of course, one could also introduce an “own” rate of return into the money demand formulation. This would certainly be advisable when dealing with broad definitions of money that include deposits paying positive rates of interest (see Mathieson (1982, 1983)). Because we work with narrow money (currency plus demand deposits) throughout, in our case this omission is obviously not serious, since demand deposits typically are non-interest-bearing.
Introducing the forward premium into the specification in place of the expected change in the exchange rate implies, of course, that the forward premium is a good approximation of the change in the future spot exchange rate.
From a methodological point of view, even if interest-parity arbitrage differentials are white noise it is still possible that other variables, besides the world interest rate and the expected rate of devaluation, will affect the domestic interest rate. For this reason a more appropriate procedure is to test directly whether other variables suggested by the theory have an effect on it.
In a more recent study of Uruguay, Blejer and Gil Diaz (1985) found that the risk premium was highly serially correlated.
During the period when the parity condition does not exactly hold there would obviously be unexploited profit opportunities. The attempts by transactors to take advantage of these opportunities would set in motion the very forces that would bring about equality between domestic and foreign interest rates (adjusted for expected exchange rate changes). How long this process takes is an empirical question and would have to be estimated from the data.
It is, of course, assumed here that the degree of openness (Ψ) is constant over time. The implications of relaxing this assumption, and the possible procedures for doing so, are considered in Section III.
Strictly speaking, in the shift from the closed economy to the open economy case the demand for money function should be generalized to allow for foreign interest rates, the expected change in the exchange rate, or both. A suggested procedure for doing so is presented in Section III (under “Effects of Currency Substitution”).
Note that when θ = 1 the lagged interest rate term would drop from the specification, so that the equilibrium model is only a restricted version of this formulation.
Note that an equation of the form of equation (14) can be derived from a portfolio model with imperfect substitutability between domestic and foreign assets.
First of all, there are few developing countries that can be viewed as completely closed; second, those that would qualify do not have developed financial systems with market-determined interest rates.
See International Monetary Fund (1984) for a detailed description of the nature and extent of capital controls in Colombia.
Even before 1978 there were no limits on residents’ investments in the Scheduled Territories (comprising the former Sterling Area). Because Hong Kong was included in the Scheduled Territories, residents could, in theory, transfer funds anywhere via the Hong Kong market, so that this restriction was not particularly effective.
Experiments with alternative approximations for the expected exchange rate, such as the fitted values from a distributed lag function of the actual exchange rate, yielded broadly similar results. This is to be expected because in Singapore the forward rate has been a reasonably good predictor of the future spot exchange rate. See Blejer and Khan (1983).
Using the actual rate of inflation (that is, the perfect foresight model) did not produce any significant differences in the results.
This assumption is consistent with independent empirical evidence on the demand for money relation for both countries—for example, Montes and Candelo (1982) for Colombia, and Khan (1981) for Singapore.
Recall that the sign of the reduced-form coefficient for expected inflation (δ4) was ambiguous; the result in Table 1 indicates that λ(1 - β)(α2 + α3) < 1.
Note that the adjustment equation (6) in our model could be interpreted as an inflation equation, although we do not explicitly do so.
Blejer and Gil Diaz (1985) specify a two-equation model for the real interest rate and inflation. Their model, of course, can be used to determine the nominal interest rate as well.
Note also that ψ would depend on the interest rate chosen. For different interest rates one could easily have different values of ψ. We are indebted to Michael Mussa for this point.
In formulating such equations, one has to recognize that the endogenous variable (ψ) is bounded (0,1). For this constraint to be taken properly into account, the precise functional forms would be more complicated than the linear ones described here.
A problem with the black market premium is that it will tend to capture a variety of factors, including the effect of actual and expected capital controls.