WPS 2-2 7 POLICY RESEARCH WORKING PAPER 2267 Public Disclosure Authorized Do High Interest Rates No - there is no systematic associationbetween interest Defend Currencies during ratesand the outcome of SpeculativeAttacks? speculativeattacks. Public Disclosure Authorized Aart Kraay Public Disclosure Authorized Public Disclosure Authorized The World Bank Development Research Group Macroeconomicsand Growth U January 2000 a tPQmI.CY RESEARCH WORKING PAPER 2267 Summary findings Drawing on evidence from a large sample of speculative The lack of clear empirical evidence on the effects of attacks in industrial and developing countries, Kraay high interest rates during speculative attacks mirrors the argues that high interest rates do not defend currencies theoretical anmbiguitieson this issue. against speculative attacks. In fact, there is a striking lack of any systematic association between interest rates and the outcome of speculative attacks. This paper - a product of Macroeconomics and Growth, Develcpment Research Group - is part of a larger effort in the group to study the causes and consequences of financial crises. Copies of the paper are available free from the World Bank, 1818 H Street,N'W, Washington, DC 20433. Please contact Rina Bonfield, room MC3-354, telephone 202-473-1248, fax 202-522-3518, email address [email protected]. Policy Research Working Papers are also posted on the Web a!t www.worldbank.org/research/workingpapers. The author may be contacted at akraay@<iworldbank.org.January 200(0. (45 pages) The Policy Research Working Paper Series dissemninatesthe findings of work in progress to encourage the exchange of ideas about | development issues. An objective of the series is to get the findings out quickiy, even if the presentations ar-eless than f7lly polished. Th2e papers carry the names of the authors and should be cited accordingly. The findings, interpretations, aisd conclusions expressed in this paper are entirely those of the authors. They do uot necessa-ily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center Do High Interest Rates Defend Currencies During Speculative Attacks? Aart Kraay The World Bank 1818H Street, N.W. Washington,DC 20433, (202)473-5756, [email protected]. The opinionsexpressed in this paperare the author's,and do not reflectthose of the World Bank, its executivedirectors, or the countriesthey represent. I would liketo thank Alan Drazen,Ilan Goldfajn,Patrick Honohan, Vickie Kraay, MariaSoledad MartinezPeria, Sergio Schmukler, Jakob Svensson, Jaume Ventura and seminar participantsat MIT, the TinbergenInstitute, and the World Bankfor helpfulcomments. 1. Introduction Accordingto conventionalwisdom, currencies that comeunder speculative attack can be defendedwith high interestrates. By raising interestrates high enough, the conventionalwisdom argues that the monetaryauthority can make it prohibitively costlyfor speculatorsto take short positionsin the currencyunder attack. High interest rates are often alsosaid to conveya positivesignal regardingthe commitmentof the monetaryauthority to maintaininga fixed exchangerate. To the extentthat this signal alters the expectationsof foreign exchangemarket participants,high interestrates can serve to strengthenthe domesticcurrency. A classicexample in supportof the conventionalwisdom is the responseto the attackon the Swedishkrona in the summer of 1992,shown in the top panelof Figure 1. BetweenJuly and August,speculative pressuresagainst the krona resultedin a loss of nearlyone-quarter of the reservesof the Swedishcentral bank. To stemthe outflow,the centralbank's marginal lending rate was raisedto an incredible500 percenton September17 and 18, and hoveredin the vicinity of 50 percentfor the nextweek. Reservelosses were promptlyhalted, and the krona'speg was maintained. Recently,a contrarianview of the effects of high interestrates duringspeculative attackshas emerged,which calls into questionboth tenets of the conventionalwisdom. First, it notesthat interestrates haveto be increasedto very high annualizedrates in order to enticeeven risk-neutralinvestors to hold local currency-denominatedassets in the face of a small expecteddevaluation over a short horizon,and suchextremely high interestrates are rarely observedin practice.' Second,this view notesthat the signaling value of high interestrates is unclear. Althoughsignals must be costly in orderto be credible,often they imposecosts that are too high for the monetaryauthority to take in stride. If marketparticipants know that the monetaryauthority is concernedabout the contractionaryeffects of high interestrates on domesticeconomic activity, they are unlikelyto believethat rates will be kept high enough,and for long enough,to deter speculation.Worse, as the costsof high interestrates mount,the monetaryauthority's signalcan becomeless credibleover time, raisingdevaluation expectations. A vicious 1For example,a risk-neutralinvestor expecting only a 0.5 percentovernight depreciation would requiie an overnightannualized rate of returnof 500 percenton domesticcurrency to compensatefor the expected devaluation. 1 spiral can result,as expectationsof a devaluationforce higher interestrates, which in turn imposegreater costs on the economy.2An exampleconsistent with this contrarian view of the effects of high interestrates is Koreain the secondhalf of 1997,shown in the lower panelof Figure 1. As the EastAsian financial crisis spread from Thailandand Malaysia,speculative pressures against the Koreanwon intensifiedand the reservesof the Koreancentral bank fell from 35 billionto 25 billion US dollars betweenJune and November.Although the overnightcall rate was raisedfrom around 12 percentin early Novemberto over 30 percentby the end of December,the won fell by over 50 percent duringthis period. In light of thesetheoretical ambiguities and conflictinganecdotes, this paper asks whetherthere is any systematicempirical evidence in supportof the conventional wisdomregarding the effects of high interestrates during speculativeattacks. To answerthis question,I study the behaviourof interestrates around a large numberof successfulspeculative attacks (i.e. attacksthat end in a sharp nominaldevaluations) andfailed speculativeattacks (i.e. attacksthat did not end in a devaluation)in a sample of 75 developedand developingcountries over the period 1960-1997. I examine whetherinterest rates rise duringfailed speculaltiveattacks (i.e. whetherraising interest rates is necessaryto preventa speculativeattack from endingin a devaluation),and whetherraising interest rates increasesthe probabilitythat an attack fails (i.e.whether raisinginterest rates is sufficientto preventa speculativeattack from endingin a devaluation). This empiricalexercise faces threedifficulties: measuring the policy responseto a speculativeattack, accountingfor possiblenon-linearities in the effectsof the policy response,and controllingfor the endogeneityof the policy response. First, it is difficult to disentanglethe monetarypolicy response to a given speculativeattack from other sourcesof variationin observedmarket interest rates duringthe attack. For example, increasesin marketinterest rates duringa speculativeattack might reflectboth a tighteningof domesticcredit by the monetaryaLuthority, and also an increasein the 2Drazen and Masson(1994) developa modelin whichsignals become less credibleover time. Bensaid and Jeanne(1997) formalize devaluation spirals. Radeletand Sachs(1998) and Furmanand Stiglitz (1998)discuss other reasonswhy tighter monetarypolicy can weaken,rather than strengthen,the currency underattack. 2 devaluationexpected by marketparticipants. In order to obtain a direct measureof the monetarypolicy responseto speculativepressures, I rely primarilyon changesin interestrates underthe controlof the monetaryauthority (i.e. centralbank discount rates) as a measureof policy. A drawbackof this measureis that discountrates are only one of many instrumentsthat the monetaryauthorities have at their disposalto resist speculativepressures. I thereforealso check the robustnessof the resultsusing a variety of other noisierindicators of the stance of monetarypolicy. Second,there may be importantnon-linearities in the effects of interestrates on speculativepressures, and ultimatelyon the outcomeof the attack. For example,the credibilityof the monetaryauthority's signal of its intentto defend the currencymay dependon the economy'sability to withstandthe contractionaryeffects of tight monetary policy,or on the quantityof reservesheld by the monetaryauthority. In this case, simplecorrelations between measures of monetarypolicy and the outcomeof speculativeattacks may obscureany effectsof policy presentonly in certain subsamplesof speculativeattacks. I take into accountthe possibilityof episode-specific variationin the effects of monetarypolicy by splittingthe samplealong various dimensions,and by interactingmeasures of monetarypolicy with episode-specific characteristics. 3 Third and perhapsmost important,the policy decisionsof the monetaryauthority are themselvesendogenous, and are likely to dependon both episode-specific characteristicsthat determinespeculative pressures, and on speculativepressures themselves.Consider an economythat is vulnerableto a speculativeattack, perhaps becauseits real exchangerate is overvaluedor its reservesare low relativeto its short- term obligations. If attackson vulnerablecurrencies are both more likelyto succeed,