NBER WORKING PAPER SERIES A SIMPLE TEST OF THE EFFECT OF INTEREST RATE DEFENSE. Allan Drazen Stefan Hubrich

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1 NBER WORKING PAPER ERIE A IMPLE TET OF THE EFFECT OF INTERET RATE DEFENE Allan Drazen efan Hubrich Working Paper hp:// NATIONAL BUREAU OF ECONOMIC REEARCH 1050 Massachuses Avenue Cambridge, MA Ocober 2006 Paper presened a he 18h Annual TRIO Conference, Tokyo, Japan, December 2005 and forhcoming in he Journal of he Japanese and Inernaional Economies. For useful commens, we wish o hank our discussans, hin-ichi Fukuda and higenori hirasuka, as well as Takaoshi Io, Andrew Rose, and oher conference paricipans. Corresponding Auhor: Allan Drazen, Universiy of Maryland, NBER and CEPR. efan Hubrich is currenly employed as a quaniaive analys in he equiy division of T.Rowe Price Associaes, Inc., in Balimore/UA. The views expressed herein are hose of he auhor(s) and do no necessarily reflec he views of he Naional Bureau of Economic Research by Allan Drazen and efan Hubrich. All righs reserved. hor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full credi, including noice, is given o he source.

2 A imple Tes of he Effec of Ineres Rae Defense Allan Drazen and efan Hubrich NBER Working Paper No Ocober 2006 JEL No. F31,F33 ABTRACT High ineres raes o defend he exchange rae signal ha a governmen is commied o fixed exchange raes, bu may also signal weak fundamenals. We es he effeciveness of he ineres rae defense by disaggregaing ino he effecs on fuure ineres raes differenials, expecaions of fuure exchange raes, and risk premia. While much previous empirical work has been inconclusive due o offseing effecs, ess ha disaggregae he effecs provide significan informaion. Raising overnigh ineres raes srenghens he exchange rae over he shor-erm, bu also leads o an expeced depreciaion a a horizon of a year and longer and an increase in he risk premium, consisen wih he argumen ha i also signals weak fundamenals. Allan Drazen Deparmen of Economics Universiy of Maryland College Park, MD and NBER drazen@econ.umd.edu efan Hubrich T.Rowe Price Associaes, Inc 100 Eas Pra. Balimore, MD sefan_hubrich@roweprice.com

3 1. Inroducion Raising he shor-erm ineres rae is ofen used o defend a currency under aack. The ineres rae defense has had boh successes and failures, some quie specacular. Hong Kong increased overnigh raes o several hundred percen and successfully defended is currency in Ocober 1997 agains speculaive aack. weden similarly increased is ineres rae by several hundred percen in is currency defense in epember 1992, bu he success was shor-lived. Oher cases of boh success and failure can be cied, so ha even a firs look a episodes leaves very much open he quesion of he effeciveness of an ineres rae defense. Formal economeric ess of his quesion are also inconclusive. As Kraay (2003, p. 297) pus i, in speculaive aacks in developed and developing economies, here is a sriking lack of any sysemaic associaion whasoever beween ineres raes and he oucome of speculaive aacks. Hence, we really have no clear answer o he quesion: Is raising he ineres rae effecive in defending a currency? This leads o a more fundamenal quesion, namely: Why do high ineres raes deer speculaion? The sandard argumen is ha hey increase he opporuniy cos of speculaion. When speculaors borrow domesic currency o speculae agains a fixed exchange rae (when hey shor he domesic currency), high shor-erm ineres raes make such borrowing very cosly. However, his argumen runs ino a simple arihmeic problem. If he horizon over which devaluaion is expeced is exremely shor, ineres raes mus be raised o exraordinarily high levels o deer speculaion even when he expeced devaluaion is small. For example, even if foreign currency asses bore no ineres, an expeced overnigh devaluaion of 0.5 percen would require an annual ineres rae of over 500% (( )* 100 = 517) o make speculaion unprofiable. (ee, for example, he discussion in Furman and igliz [1998].) This reasoning has called ino quesion how effecive very high overnigh ineres raes can be in deerring an aack, and has been used o explain why he ineres rae defense may be ulimaely unsuccessful. Though he arihmeic problem addresses he quesion of why specacular defenses may have only limied effecs, i raises oher quesions. On he one hand, why hen is he ineres rae defense someimes successful, especially when he ineres rae used o defend is no specacularly high? And, why do shor-lived increases in ineres raes ofen appear o have much longer-erm effecs? On he oher hand, why does an ineres rae defense 1

4 someimes appear o lead o even greaer speculaive pressures agains he currency? The effecs of raising ineres raes mus reflec more han a simple cos-of-borrowing effec. In his paper we invesigae hese quesions by decomposing he effecs of an increase in he ineres rae on he shor-run expeced exchange rae ino a number of (poenially offseing) effecs. Our focus is empirical, bu one suggesed by a specific concepual approach o he effeciveness (or ineffeciveness) of ineres rae defense. We argue ha he effecs of high ineres raes may reflec he informaion ha increasing ineres raes provides o marke paricipans. If so, he direc cos implicaions of high ineres raes for speculaors may be secondary o he signal hey provide. By raising ineres raes, a governmen signals ha i is commied o fixed exchange raes, bu i may also signal weak fundamenals. Hence, a key empirical implicaion is ha raising ineres raes leads o he expecaion ha fuure raes will be high, bu may also increase he probabiliy speculaors assign o collapse. As a consequence, he ne effec may be ambiguous. A key argumen is ha if he effecs of high ineres raes reflec he expecaions hey engender abou fuure policy (via he signal abou unobserved governmen characerisics under asymmeric informaion), hen hese effecs should appear in expecaions of fuure exchange and ineres raes. Hence, ess of he effeciveness of he ineres rae defense looking a hese forward-looking variables should be informaive. Empirical esing along hese lines is he focus of his paper. Our main conclusion is ha while ess looking a he effec of high ineres raes on summary measures like he oucome of an aack (or he very shor-erm expeced exchange rae) are ofen inconclusive, ess ha disaggregae hese effecs boh across differen ime horizons and across differen deerminans of shor-erm expeced exchange raes (ineres differenials, risk premia, and long-erm expecaions) provide significan informaion. The inconclusiveness of ess using summary measures may be due o offseing effecs, wih ess on disaggregaed measures displaying some clear regulariies o explain hese offseing effecs. Raising overnigh ineres raes srenghens he exchange rae over he shor-erm for mos counries in our sample via is effecs on shor-erm ineres rae differenials, consisen wih signaling commimen o defend. However, raising overnigh ineres raes leads o an expeced depreciaion a a horizon of a year and longer, consisen wih he argumen ha i also signals weak fundamenals. High overnigh raes also weaken he exchange rae via an increase in he 2

5 risk premium, consisen wih he argumen ha hey increase he risk of defaul. The plan of he paper is as follows. In he nex secion, we quickly review sandard empirical ess of he ineres rae defense, in which he probabiliy of he fixed rae regime being mainained is relaed o he sance of moneary policy. Given he inconclusiveness of he ess, we argue ha an alernaive approach is required. In secion 3, we consider ess of he effecs of he ineres rae defense via he erm srucure of exchange rae expecaions and ineres raes, using daa from eigh European counries. We show ha disaggregaing he effec of raising overnigh ineres raes in he way oulined in he previous paragraph provides significan informaion ha is hidden in a es on a summary measure. These resuls are consisen wih he signaling hypohesis, bu also in par wih oher argumens, as we will ouline. ecion 4 presens a summary of our main findings, as well as concluding commens. 2. Tesing he Effeciveness of Ineres Rae Defense We begin by reviewing he evidence on ess of he effeciveness of raising he ineres rae o defend agains speculaive aack, as well as concepual argumens on why such ess may be inconclusive. The mos obvious es is o relae some measure of he level of ineres raes or moneary policy o aack oucomes. Recen empirical lieraure has produced a number of empirical ess of he effeciveness of ineres rae defense of his sor. The bes known paper is probably ha of Kraay (2003), who sudies a large cross-counry sample of fixed exchange rae crises, and relaes he sance of moneary policy o he oucome of he crisis (collapse or survival of he peg). He uses an insrumenal variable probi echnique o conrol for he endogeneiy of he ineres rae, since boh he degree o which a counry raises ineres raes and he probabiliy ha an aack succeeds (for given ineres raes) are likely o depend on he amoun speculaive pressure i faces. Hence, heavy speculaive pressure may lead a counry o raise ineres raes sharply bu may also make failure likely, so ha here is a correlaion beween ineres raes and aack oucomes ha has nohing o do wih he effeciveness of ineres rae defense ceeris paribus, ha is, when speculaive pressure or characerisics are conrolled for. 1 As indicaed above, he finds lile significan relaionship 1 For example, Hubrich (2001) shows ha high-inflaion counries are more likely o face a successful speculaive aack, and are more likely o resor o an ineres rae defense when facing an aack. Thus, high ineres raes are associaed wih successful aacks (a failed defense) in a cross-counry sudy, even 3

6 beween moneary policy and aack oucomes one way or he oher. Oher sudies of his sor include Goldfajn and Gupa (1998) and Dekle, Hsiao, and Wang (1999), who find more suppor for he convenional view. On he whole, he evidence is inconclusive. Theoreically, he inconclusiveness of ess should no be surprising. To see why, consider he uncovered ineres pariy condiion * i = i + + 1, + P (1) where i and i * represen he domesic and inernaional ineres rae, respecively, and is he (log of he) exchange rae in erms of domesic per uni of foreign currency. + k, denoes he expecaion wih respec o period +k, formed in period (so ha + 1, is simply he oneperiod ahead devaluaion expecaion). P, he residual from uncovered ineres pariy, capures a currency and a defaul risk premium. peculaive pressure on would be refleced in increases in he expeced one-period ahead exchange rae or in he risk premium P, so ha ineres rae defense could be hough of as he policy of leing i increase along wih devaluaion pressure on he righ-hand side o leave + 1, unchanged. Hence, for a given amoun of speculaive pressure (he righ-hand side componens of (1) oher han i * and ), a high enough nominal ineres rae will successfully defend he peg in he very shor erm, ha is, i will ensure ha ineres rae pariy holds. However, one canno hold oher componens of (1) consan. Pu anoher way, a failure of he policy of raising ineres raes mus reflec higher ineres raes increasing speculaive pressure agains he exchange rae, refleced in a posiive effec on or P, a possible + k, perverse feedback effec. 2 Hence, insead of relaing ineres raes o exchange rae oucomes, one really needs o examine wheher here are feedback effecs from ineres raes back o speculaive pressure. 3 Why migh raising ineres raes have he effec of raising speculaive pressure? One hough ineres rae defense may have been effecive on a per-counry basis, conrolling for inflaion. 2 One mus disinguish an aack ha succeeds due o he failure of a defense from an aack ha succeeds because he governmen chooses no o defend. If defense requires an exremely high ineres rae mainained over some period of ime, he governmen may find i oo cosly o defend. 3 Hubrich (2001) proposes o look no a he relaionship beween ineres raes and exchange rae oucomes, bu a ha beween ineres raes and speculaive pressure (as idenified hrough a srucural economeric model), and o esimae he feedback effecs implied by differen models. 4

7 argumen is ha high ineres raes cause he fundamenals hemselves o deeriorae, an argumen suggesed by Drazen and Masson (1994). For example, if pressure agains a currency reflecs he belief ha a weak fiscal posiion means ha deb will have o be moneized, hen raising ineres raes only worsens he fiscal posiion, raising expecaions of furher moneizaion. This argumen is explored in deail by Lahiri and Végh (2003). Alernaively, higher ineres raes may desabilize an already weak banking sysem, leading o he belief ha defense of he fixed exchange rae mus soon be abandoned (see, for example, Furman and igliz [1998] or Radele and achs [1998]). A differen ype of argumen is suggesed by Drazen (2000, 2003), namely, signaling of unobserved governmen characerisics. Tha is, here are unobserved characerisics of he governmen ha affec he probabiliy ha a defense will be mouned or coninued, wih policy choices being correlaed wih hese characerisics. Hence, wih imperfec informaion abou hese governmen characerisics, speculaors use observed policy choices o make inferences abou hem and hence form (ha is, updae) he probabiliy hey assign o a devaluaion. Raising ineres raes herefore may affec speculaor s behavior because i serves as a signal of he governmen s willingness or of is abiliy o defend he exchange rae. (This argumen may be seen as more generally concerning exchange rae inervenion.) The signaling view suggess no only why raising ineres raes may increase speculaive pressures, bu also why he effec may be ambiguous, leading o inconclusive empirical ess. The effec of raising ineres raes on speculaive pressure depends on wha speculaors believe i is signaling. If very high ineres raes are aken as indicaing he governmen's deerminaion o defend he exchange rae (no maer wha he cos, one is emped o add), hen high ineres raes may succeed in lowering speculaive pressure. This is cerainly he signal governmens ha engage in specacular defenses would like o send. However, very high ineres may be aken o indicae very weak fundamenals (or, more generally, panic ), in which case here will be a perverse effec raising ineres raes would only encourage speculaion. If he signal conen of high ineres raes is imporan, empirical ess in a cross secion of counries may be inconclusive if differen hings are being signaled in differen counries. Moreover, even wihin a counry a a poin in ime, he effec may be ambiguous if he signal is mixed or unclear, ha is, if speculaors infer ha boh willingness o defend and weak fundamenals are being signaled, or if hey are unsure wha is being signaled. I may also be ha 5

8 differen unobserved characerisics are being signaled a differen horizons, a poin ha we sress in our empirical ess. A furher implicaion of he signaling approach is ha here may be disproporionaliies in he effec of ineres raes on speculaive aciviy. Raising ineres raes may dampen speculaion far more han an arihmeic argumen may sugges or may have lile effec. To he exen ha i sends a negaive signal, i may acually increase speculaive pressures. If a persisen fundamenal is signaled, hen a shor-lived increase in ineres raes may have a much longer-erm effec. Finally, he effecs may be no only of differen srenghs a differen horizons, bu also of differen signs, raising ineres raes srenghening he exchange rae in he very shor erm, bu weakening i a a longer horizon. We now urn o empirical assessmen of ineres rae defense on he basis of hese insighs. 3. The Effec of Raising Ineres Raes a Differen s A naural direc es of hese ideas consiss of relaing exchange rae expecaions and risk premia a differen horizons o ineres rae policy. Therefore his secion uses a se of survey daa for exchange rae forecass a differen horizons o sudy he effec of ineres raes on exchange rae expecaions during he 1992/3 ERM crisis. The analysis is geared owards invesigaing a number of possible effecs. Firs, he impac of ineres raes on exchange rae expecaions is allowed o be non-linear, consisen wih he argumen ha he informaion conen of he policy may no be proporional o he level of he ineres rae. econd, signaling models also sugges ha emporary policies have longer-run effecs, in ha he signaling effec of high ineres raes may oulas he high ineres rae policy iself. This can be examined by looking a he erm srucure of exchange rae expecaions: Does ineres rae policy affec exchange rae expecaions similarly a all horizons, or does i only have an impac on shor-erm expecaions? The more he effec is spread ou across he erm srucure, he more i would seem ha somehing fundamenal is being signaled. In addiion, he analysis enables us o disinguish beween he effecs of policy on fuure ineres raes and hose on risk- and erm premia (wih he effec on exchange rae expecaions being he sum of boh). A. Empirical Framework 6

9 Recalling ha X + j, refers o he expecaion of he value of X a ime +j as formed a ime (he curren value is denoed k k k X X, ), we wrie he ineres pariy condiion (1) as: d i = +, + P (1a) Here k denoes he mauriy of he underlying asse (in oher words, we are looking a, say, a k- k k * k k monh money marke rae). di is he ineres rae differenial i i and P is he risk premium from o +k (which may include a erm premium, a currency risk premium, and a defaul risk premium). Using monhly daa for exchange rae expecaions and money marke raes a he 1, 3, 6 and 12-monh horizon, we can use (1a) o decompose nex monh s expeced exchange rae +1, ino: + 1, ( + 1, + 3, ) + ( + 3, + 6, ) + ( + 6, + 12, ) , =, (2) where , + 3, = ( P P ) ( di di ) (3a) = ( P P ) ( di di ) (3b) 3, 6, = ( P P ) ( di di ) (3c) 6, 12, +1, In oher words, he above allows us o decompose nex monh's expeced exchange rae ino he accumulaed effecs of ineres rae expecaions and risk over four differen horizons. (Noe ha under a pure expecaions hypohesis of ineres raes, i k + j i k is he expeced ineres rae over he j-monh inerval from +k o +k+j, so ha di k +1 di k is he onemonh ineres differenial expeced for +k as of. Oher differences in (3) have similar inerpreaions.) As ineres raes increase and risk decreases, he exchange rae componens decrease (i.e., he exchange rae appreciaes). This represens he common inuiion underlying he ineres pariy condiion ha higher ineres raes will appreciae exchange raes, while increases in risk premia (if no mached by ineres raes) will lead o a depreciaion. A key noion o ake away from his decomposiion is ha +1, is essenially a sum ha we can break down ino seven individual componens along wo dimensions erm and he componens of ineres raes versus risk premia. This is illusraed by he following able: 7

10 TABLE 1 Deerminans of he Expeced Exchange Rae + 1, Term Componen 2-3 mo. 4-6 mo mo. 12+ mo. um 1 3 Ineres Raes di d i di d 3 6 i di d 6 12 i di d 1 12 i 3 1 Risk P P P 6 3 P P 12 6 P P 12 1 P Long-Term + 12, + 12, um + 1, + 3, + 3, + 6, + 6, + 12, + 12, + 1, By examining how each of he inner componens reacs individually o ineres rae policy (idenified as changes in a very shor-erm money marke rae), we hope o beer undersand he effecs of raising ineres raes and o be able o disinguish signaling effecs from oher, compeing hypoheses. In general, we would expec ha if ineres rae policy bears an informaion conen ha oulass he policy iself, hen ineres rae policy should have longererm effecs. These would show up in he above decomposiion as decreases in he ineres rae componens (represening increases in ineres rae expecaions) ha are spread ou across he differen horizons. To make his clearer, suppose firs ha an increase in he overnigh policy rae is seen as providing no informaion abou fuure ineres rae policy. (Assume for simpliciy of exposiion ha erm premia are zero, so ha he k-monh ineres rae is simply he sum of expeced onemonh ineres raes from o +k.) If he cenral bank raises he overnigh ineres rae policy rae) in response o an aack, his migh raise ineres raes a very shor horizons, bu in he absence of informaion effecs, here would be no significan effec on ineres raes beyond he erm over which he policy rae is kep high. Consequenly, only he analogous shor-erm componens of +1, in (3) would improve. For example, suppose i is believed ha a high overnigh rae a will be mainained for a k week o fend off an aack and hen brough back down. The ineres rae differenial a, di, for every horizon k will increase, bu he ineres raes for periods beyond he week (ha is, di d 3 1 i 6 3, di d, e ceera in he monhly daa) would be unchanged. By equaions (3) he i 8 r (he

11 expeced exchange rae beyond he one-week horizon (he lef-hand side of he equaions) would also be unchanged. ince +1, is simply he sum of hese erms as in (2), i would be unaffeced as well in he absence of informaion or signaling effecs. In conras, now suppose ha he emporary policy signals a permanen change in he policy sance in he sense of a commimen o supporing he exchange rae. This ranslaes ino permanenly higher expecaions of he one-monh ineres rae ( permanen as long as his commimen is believed o hold), so ha he ineres rae componens a all horizons in (3a)-(3c) will decrease. This will appreciae exchange rae expecaions across he board and resul in a posiive appreciaion, as compared o he zero effec when informaion or signaling effecs are absen. As discussed above, his is he signal a defense is mean o send Finally, he decomposiion of he exchange rae erm componen ino an ineres rae erm and a risk erm allows us o analyze separaely he effec on he risk- and erm premia. For example, if he achs-igliz argumen is correc (whereby higher ineres raes may weaken he banking secor), we should deec an increase in he risk componens in response o an ineres rae policy hike, as risk premia increase. 4 This would be anoher perverse feedback effec. B. Daa and Regression Equaions To perform he decomposiion implied by equaions (2) and (3) as illusraed in he marix, we use monhly daa for nine European counries Germany, Belgium, France, Ialy, Denmark, weden, Norway, Ireland and pain 5 for he ime period around he 1992/3 ERM crisis o consruc monhly ime series for hose seven componens. The daa cover he period of 4 As daa are available for exchange rae expecaions and ineres raes over differen horizons, we are k able o obain daa for P as he residual from ineres raes and exchange rae expecaions a he differen horizons, essenially using (3). If ineres rae forecass and k-monh forward raes were consisenly k available as well, we could also decompose P ino hree componens (a currency risk, defaul risk, and erm premium). Ineres raes forecass were indeed available for a small subse of he daa, and were used for a cursory exploraion of he role of erm premia. Forward rae daa were available hroughou we refrained, however, from using hem o make a disincion beween currency and defaul risk since his disincion is no he focus of our presen work. 5 An obvious and ineresing addiional counry would have been he UK. Unforunaely, we were unable o obain sufficienly long money marke rae series from Bloomberg (which is he source for he money marke daa for all he oher counries). This reflecs in par he lack of daa a he beginning of he sample period, and in par he fac ha he pound serling lef he EM in he fall of 1992, hus shorening he relevan period o begin wih. 9

12 1989: :12 for mos counries 6. During his period hose counries essenially had heir exchange raes fixed agains he benchmark counry Germany. 7 These daa permi o consruc he four exchange rae series on he righ-hand side of (2), hus permiing us o look a he erm srucure of exchange rae. Exchange rae forecass were published monhly in he Financial Times Currency Forecaser. This is a combined consensus forecas, he geomeric mean of a sample of professional currency forecass from commercial banks and oher mulinaional corporaions. 8 The reference currency for hese forecass is he U Dollar, so he U Dollar/DM forecas has been used o consruc exchange rae forecass relaive o he DM. The forecass come ou monhly on he fourh Thursday of he monh, from daa gahered earlier in he week. k-monh ineres rae differenials (wih respec o Germany) are represened hrough money marke raes (from he day of he exchange rae forecas) ha were obained from Bloomberg. The risk daa could hen be backed ou as he residual, according o (3a)-(3c). The following seven equaions were esimaed for each counry (one for each cell in j, n j n Table 1), where for convenience we define X X X : 1,3 2 di c1 + a1d r + b1 ( d r ) + f1 + ε1 = (4a) di 3, 6 2 c2 + a2dr + b2 ( dr ) + f 2 + ε 2 = (4b) 6,12 2 di c3 + a3dr + b3 ( dr ) + f3 + ε3 = (4c) 3,1 2 P c4 + a4dr + b4 ( dr ) + f 4 + ε 4 = (4d) 6,3 2 P c5 + a5dr + b5 ( dr ) + f5 + ε5 = (4e) 12,6 2 P c6 + a6dr + b6 ( dr ) + f 6 + ε6 = (4f) 6 horer ime periods are used due o limied daa availabiliy (Ialy, weden, Ireland) or in cases where counries lef he EM and/or he exchange rae was officially floaed afer he crisis (Ialy, weden, Norway), in order o keep he sample resriced o fixed episodes 7 Technically, wih he excepion of Norway and weden, hese counries were par of he EM sysem where each counry agreed o fix is currency o wihin a band around a weighed baske of all oher paricipaing currencies. Treaing Germany as he (sole) benchmark counry simplifies he analysis, and is jusified in ligh of he fac ha he DM had he bigges weigh in ha baske. 8 Opimally, one would like o use expecaions a a higher (say weekly) frequency o examine he very shor-run effecs of ineres rae increases on he expeced exchange rae. Unforunaely, such daa do no exis, a leas for his se of currencies in his ime period. 10

13 2 12, = c7 + a7dr + b7 ( dr ) + f 7 + ε7 + (4g) dr r The main regressor is an overnigh or one-day money marke rae differenial r *, which presumably reflecs he degree o which he governmen chooses o engage in an ineres rae defense. ome of he governmens in he sample acually increased overnigh raes o engage in ineres rae defense, which should be picked up well by hese very shor-erm raes. Oher governmens merely engaged in ineres rae defense o he exen ha hey chose no o inervene, and le money marke raes be driven up by devaluaion expecaions. This ineres differenial is obained as he average (from daily observaions) beween wo exchange rae forecass, expressed in percenage poins. I is allowed o ener squared as well, in order o assess non-lineariies relaed o signaling. The only oher regressor (aside from a consan) is, he acual observed exchange rae a he ime of he forecas. This regressor was included o ry o conrol, a leas parially, for poenial biases semming from he endogeneiy of he policy measure dr r r *. I is likely ha he same facors ha affec policy (he onse of a crisis, speculaive pressure ec.) also have a direc effec on he dependen variable hrough he error erm ε, which migh lead o an endogeneiy bias in he coefficiens a and b. To he exen ha hese facors also lead o movemens of he acual exchange rae (wihin is band 9 ), including he exchange rae can conrol for his effec. Due o a lack of good insrumenal variables we have been unable o rea endogeneiy more formally, so ha we canno be enirely cerain ha he esimaion is free of biases semming from endogeneiy. In order o be able o focus on he erm srucure (wihou disinguishing beween ineres rae and risk componens), he following hree equaions were also esimaed (he implied equaion for +12, is idenical o (4g)): 2 1, + 3, = c8 + a8dr + b8 ( dr ) + f8 + ε8 + (5a) 9 During he crisis, here were subsanial flucuaions wihin he band, and periods of srong speculaive aacks were ofen characerized by he fac ha he exchange rae under aack hi he boundary of he band. In addiion, here were realignmens and widening of bands during he esimaion period. Including he acual exchange rae as a regressor is a naural way of rying o conrol for such evens. 11

14 2 3, + 6, = c9 + a9dr + b9 ( dr ) + f9 + ε9 + (5b) 2 6, + 12, = c10 + a10dr + b10 ( dr ) + f10 + ε10 + (5c) Noe ha since he risk premia P were backed ou reaing (3a)-(3c) as an ideniy, he esimaed coefficiens in (5a)-(5c) are linked o hose in (4a)-(4g) by consrucion: a 1 + a 4 = a 8, a 2 + a 5 = a 9, and so forh. The economic equivalen of his is ha he effec of ineres rae policy on exchange rae expecaions is he sum of is effec on ineres raes and risk premia (see able 1). Before running he acual regressions, we explored he ime-series properies of he daa wih a baery of uni-roo ess. We found ha for he majoriy of he series we could rejec he uni roo hypohesis a he 10% level, using augmened Dickey-Fuller ess ha included a consan erm bu no rend. Mos failures o rejec he uni-roo hypohesis occurred for ineres rae series, where we could rejec he uni-roo only for abou 50% of he series. ince nonsaionary ineres raes are difficul o concepualize economically, we aribue hese failures o he weakness of he ess due o he generally small sample size for he regressions. Therefore, being aware of he problems involved wih over-differencing he daa, we decided o run he regressions in levels as laid ou above. C. Esimaion and Reporing of Resuls We esimaed equaions (4a)-(4g) or (5a)-(5c) on a counry-by-counry basis using GMM. andard errors are boh heeroskedasiciy-consisen and accouning for up o 12 auocorrelaion lags in he (monhly) daa. In addiion we esimaed wo cross-counry versions of he model, disinguishing beween crisis and non-crisis periods. 10 In he absence of an exogenous crisis indicaor, we chose o look a ineres rae levels in order o make his disincion. Ineres raes generally were higher during he beginning of he sample in 1989, came down as inflaion expecaions were reduced and moneary policy aligned in EM member counries, and finally sho up sharply saring in he fall of 1992 wih he onse of he various crises. This paern implies ha differeniaing 10 There are wo excepions o using GMM. Firs, here where no enough daa available o include auocorrelaion lags for Ialy. econd, he cross-counry samples ( crisis and no crisis ) were esimaed wihou auocorrelaion lags as well due o he pachy naure of he sample, wih crisis and non-crisis periods alernaing hroughou he sample. 12

15 beween periods simply by picking an ineres rae hreshold level for idenifying crisis periods would be misleading. We chose a heurisic approach insead, noing ha he firs (ineres rae) signs of he looming ERM crisis appeared in December of 1991 in weden. We ook ha dae as he dividing line and labeled he period 1989: :11 no crisis and he period 1991: :12 crisis for all counries, keeping in mind he sysemic naure of he crisis as well. The daa were pooled in he wo sub-samples, effecively forcing coefficiens o be idenical across counries. ince he policy variable of ineres, dr r r, eners he regression quadraically, he poin esimaes of he coefficiens are difficul o inerpre. Therefore in ables 2-11 we repor, for each sample, wo blocks of resuls. The op block of each able shows he esimaed coefficiens a and b for he various regressions in (4a)-(4g) and (5a)-(5c), which reflec he (possibly non-linear) impac of he policy variable on he corresponding componen. The boom block hen focuses on he economic meaning of he poin esimaes, as we discuss below. ince eiher equaions (4a)-(4g) or equaions (5a)-(5c) were esimaed simulaneously, he op block also repors some Wald ess of cerain cross-equaion resricions. In he las column of he able we shows ess agains he null hypohesis ha all he coefficiens b in he regression are equal o zero, in effec esing for he overall non-lineariy presen in he regression. I urns ou ha lineariy is rejeced hroughou, wih very few excepions. For hese wo counries, lineariy was rejeced when looking a he ineres rae and risk componens separaely. A he boom of he op block, we show ess of he imporance of spliing up a given erm componen ino an ineres rae and a risk componen. For ha spli, i ess wheher he coefficiens a and b are idenical across ineres rae and risk equaions. While equaliy someimes canno be rejeced for individual coefficiens, especially for he early 2-3 monh erm, i is mosly rejeced for boh coefficiens combined, especially when all erms are considered simulaneously. To summarize, he Wald ess rejec boh he lineariy of he impac of he policy rae, and he equaliy of ha impac across ineres rae versus risk componens. This poins owards he non-lineariies o be expeced from a signaling environmen, and i suggess ha he disincion beween ineres rae and risk componens will yield addiional insigh. In he boom block of each able, we use he poin esimaes o calculae he impac of an increase in he policy rae a differen horizons. A negaive value implies ha increasing he * 13

16 ineres rae reduces he erm componen, and herefore appreciaes +1,. In paricular, posiive signaling (for example, wih high ineres raes signaling srong commimen o defend) would imply a negaive enry in he case of or di. We show, for each esimaed equaion, he impac of hree differen size ineres raes increases in he policy ineres rae on he dependen variable, aking ino accoun he nonlineariy inheren in he poin esimaes of a and b an increase in he policy rae by one percenage poin over he sample mean; an increase by half he difference beween he sample mean and he sample maximum; and, finally, an increase all he way o he sample maximum. In he laer wo cases he change in he dependen variable was divided by he size of he increase in order o ge he effec per percenage poin increase, which in urn allows us o compare he hree numbers. The dependen variable is measured as 100 x ln(.), while he policy measure is expressed in percenage poins. Therefore he able enries can be inerpreed as elasiciies, giving he percenage change in a +1, componen per percenage poin increase in he overnigh ineres rae differenial. For any size ineres rae increase, he overall effec on exchange rae expecaions across he erm ( in he boom rows) can be decomposed ino an ineres rae effec di and a risk effec P, he firs and second rows, as in Table 1 above. By consrucion, he enry in he rows is he sum of he corresponding di and P enries. As can be seen in Table 1, he effec of raising he overnigh ineres rae on he one-monh-ahead expeced exchange rae +1, is he arihmeic sum of hree componens he effec on he ineres rae over he welve-monh horizon, he effec on risk premia over he welve-monh horizon, and he effec of he expeced exchange rae a a horizon of greaer han welve monhs. We use his below in inerpreing he resuls. Looking down he rows for one componen in a block, one can idenify (and quanify) non-lineariies in he ineres rae effec. A perfecly linear relaionship (b = 0) would yield idenical enries in each row. By conras, a concave relaionship (where small ineres rae increases already have large effecs, bu addiional increases have lile addiional effecs) would have he enries decreasing in absolue value as we are going down. Looking across he columns for one componen in a block, we can examine he erm srucure of ineres rae effecs. The lefmos column represens he neares erm (he nex wo monhs), and he erm increases as we move o he righ. The far righ column (labeled 1 14

17 monh ) repors he cumulaive effec across all erms (corresponding o he far-righ cells in able 1). D. Inerpreaion of Resuls by Counry In inerpreing our resuls, we focus primarily on he common rais across counries, where here are some clear paerns in he sample. Firs, and especially sriking, for every counry in he sample, a almos every horizon and for almos every size of change in he ineres rae, he ineres rae effecs are significan wih an increase in he overnigh ineres rae leading o an increase in he ineres rae a all horizons, which in urn srenghens he exchange rae. (Noe ha his is no jus an arihmeic shifing of he whole erm srucure, since he columns represen he j-monh ineres rae from +k o +k+j.) This is consisen wih increases in he overnigh ineres rae signaling an unobserved characerisic, such as commimen o defend he exchange rae. econd, his srenghening of he currency via he ineres rae componen generally does no however correspond o a higher one-monh-ahead exchange rae forecas, as seen in he souheas corner of he lower block in each able (he enries under 1 monh for expeced exchange raes). The effec of raising he overnigh ineres rae on +1, +1, is insignificanly differen from zero for hree of he counries in he sample (Denmark, Ialy, and weden). In hree cases raising overnigh raes acually leads o an expeced depreciaion one monh ou (Belgium, France, and Ireland). In only wo of he eigh counries, pain and Norway, does raising he overnigh rae lead o an expeced srenghening one monh ou. Even in his case, he expeced appreciaion is far less han wha he ineres rae effec alone would predic. The reason ha high ineres raes do no lead o an expeced appreciaion in our sample counries is ha he ineres rae effec is generally offse by a risk effec (a horizons greaer han one monh) of he opposie sign. This phenomenon is observed srongly and very consisenly in four of he eigh counries (Denmark, Norway, pain, and weden) and o a lesser/less consisen degree in Ialy and Ireland. I is sriking ha he ineres rae componens di and he risk componens P quie ofen have significan movemens of he abou he same size, bu in opposie direcions. Ineres rae defense herefore seems o increase ineres rae expecaions and ceeris paribus appreciae +1,, bu his is in general offse by an adverse increase in risk premia. 15

18 The wo excepions o his paern are Belgium and France, where increases in he overnigh ineres rae do no lead o a significan increase in he risk erm. One possible explanaion is ha hese counries were argued o be core counries in he ERM, and herefore may have been believed o have had a greaer abiliy o borrow reserves. 11 This would be consisen wih he model in he sense ha increases in he policy ineres rae would be less likely o be aken as a sign of low reserves. In boh cases, he posiive ineres rae effec was offse by a higher expeced depreciaion a horizons of welve monhs or greaer as a resul of he increases in he overnigh rae, as was also found in Denmark, Ireland, and Ialy. Boh he ineres rae and he risk erms are usually sronger in he longer erm, hus revealing imporan long-erm effecs for he usually shor-erm ineres rae policy. The join occurrence of hese wo effecs leads o a much smaller, more ambiguous effec on he exchange rae expecaions (he rows) across he horizon. The average effec on exchange rae expecaions seems o be a small appreciaion (a decrease) in he shor erm, coupled wih a deerioraion in he long-erm componens, yielding a slighly posiive and ofen insignifican overall effec, usually on he order of less han 0.05%. The long-erm deerioraion ends o be driven boh by higher risk premia a he 4-11 monh horizon and by a deerioraion in he expeced exchange rae 12 monhs ou. The laer could no be decomposed ino ineres rae and risk componens due o a lack of longer-erm exchange rae forecass, bu i may well be driven by risk premia as well. In oher words, i appears ha ineres rae expecaions dominae in he shor run, while risk dominaes he long run, and he wo cancel ou much of each oher along he way. Finally, regarding non-lineariies, i is ofen he case ha for any of he componens, di or P he larger ineres rae increases have differen effecs han he smaller ones. The direcion of ha non-lineariy, however, varies considerably across counries in he sample. Taken as a whole, his paern suggess ha cerainly more is going on han he mere arihmeic, opporuniy cos-based effecs of ineres rae defense. We argue ha hese resuls are consisen wih a signaling argumen. hor-erm ineres rae policy has srong effecs on he ineres rae expecaions embedded in long-erm ineres raes, wih he sign of hese effecs suggesing ha an increase in overnigh ineres raes is aken as a signal o defend he exchange 11 We are indebed o Richard Pores for poining his ou. 16

19 rae over a longer horizon. Moreover, hese effecs are ofen non-linear in naure. These findings poin owards informaion effecs riggered by ineres rae policy. Noe here ha he signaling hypohesis would suppor boh concaviies (larger increases have smaller relaive effecs) and convexiies. Concaviies could arise when he mere acivaion of ineres rae policy, even only a mild increase, signals he general preparedness of he governmen o use moneary policy in defense of he exchange rae. Convex relaionships, by conras, could arise when only unusually or unexpecedly high, exreme ineres raes signal news abou he policy. The evidence gives more suppor o he former, whereby he (informaional) effec of ineres rae increases is largely capured by small changes. An alernaive argumen for non-linear effecs is ha suggesed by Lahiri and Végh (2001). They sress he ineracion beween he direc effec of higher ineres raes on demand for domesic currency and he effec on governmen finances higher ineres raes worsen he fiscal posiion and induce he expecaion of greaer fuure moneizaion. The firs effec srenghens he domesic currency, while he second weakens i. In heir se-up, hey find ha he firs effec dominaes for small increases in he ineres rae, while he second dominaes for large increases. The effecs differ over he horizon, wih he firs effec being sronger in he shor-erm, he second in he long-erm. I is also ineresing o noe ha risk premia reac as well, and almos as srongly, o ineres rae policy. This could be associaed wih he achs-igliz argumen, grounded in he adverse effecs of high ineres raes on he domesic banking secor, and increasing defaul risk premia accordingly. However, i migh also be associaed wih a negaive signaling sory along he lines of high policy ineres raes signaling low reserves (or he lack of alernaives o an ineres rae defense). In ha case, he peg may appear weaker han previously hough, which would increase currency risk premia. E. ome Addiional Resuls The rends borne ou by he counry-specific regressions are mainly driven by he crisis sub-sample. As shown in able 10, ineres rae defense increases ineres rae expecaions (hus supporing he exchange rae ceeris paribus), bu deerioraes mid-erm risk premia as well as long-erm (ha is, 12+ monhs) exchange rae expecaions. Ineres rae defense comes ou as ineffecive overall, as he ne effec is a parially significan deerioraion of he one-monh ahead 17

20 exchange rae expecaion. The no crisis sub-sample (able 11), by conras, bears ou a convenional (beneficial) response, albei a weak one. Comparing he wo sub-samples more closely, i is ineresing o noe ha he difference in erms of he overall effec varies across ime. Compare he boom hree rows of ables 10 and 11. Overall, i appears ha during non-crisis periods igh moneary policy deerioraes he shor- o medium par of exchange rae expecaions, bu insills long-erm confidence enough so ha he overall effec is mildly supporive of he exchange rae. Crisis-periods, by conras, have he opposie paern. Ineres rae defense shores up shor- o medium erm expecaions, bu deerioraes mid- o long erm expecaions due o is effec on risk premia, wih he ne effec being adverse. A possible inerpreaion is ha during non-crisis periods igh moneary policy may signal boh negaive fundamenals and a willingness o defend he exchange rae. A conracion in a seemingly calm environmen may be perceived as a sign of imminen rouble, hus deerioraing shor- o medium erm expecaions, while longer-erm expecaions are improved in ligh of he policymaker s demonsraed resolve o suppor he exchange rae. In crisis periods, by conras, he curren negaive fundamenals are well esablished and known. High ineres raes are perceived as an effecive shor-o medium reamen of he sympoms, and sabilize exchange rae expecaions accordingly. From a long-erm perspecive, however, he perceived new degree of vulnerabiliy of he sysem, inferred from he governmen s demonsraed concern and resolve o inervene, more han ouweighs he increased confidence in is abiliy o deal wih fuure episodes, which seem sure o come. In summary: during calm episodes, igh moneary policy signals shor-erm fricions and long-erm healh. During crisis episodes, i relieves pain effecively in he shor-erm, bu emphasizes he long-erm severiy of he condiion. Anoher possible spli of he daa is ino EM and non-em counries o see if EM membership per se made a difference. ince his would have amouned o merely grouping Norway and weden in one group and all oher counries in anoher, we oped agains such a spli. However, simply examining he counry resuls wih EM membership in mind is insrucive. Mos imporanly, all of he counries ha had clearly adverse ineres rae defense resuls were EM counries (Belgium, France, and Ireland). By conras, Norway (non-em) was one of only wo counries wih a clearly beneficial overall effec. weden, he oher non- EM counry, was ambiguous overall, as were Ialy and Denmark in he EM, and pain was he 18

21 only EM counry wih a clearly effecive ineres rae defense. o in he mos general sense, here migh be an indicaion here ha non-em counries did beer han EM counries 12. A possible inerpreaion is ha he sysemic ies wihin he EM may acually have made he crisis worse for a number of reasons. For example, he EM s official correcion mechanism relied heavily on inervenions by he srong-currency counry (essenially Germany) o suppor he currencies coming under aack, eiher hrough direc inervenion or by exending credi o counries under pressure. Bu Germany, sill working ou he enormous moneary consequences of German reunificaion, was unable and/or unwilling o engage in such large-scale inervenion due o is impac on domesic price sabiliy. I argued for a re-alignmen insead, which was iniially rejeced by oher EM members 13. To he degree ha EM counries under aack resored o ineres rae defense, hey were effecively signaling ha here was lile o be expeced in erms of inervenions by Germany, which was conrary o how he EM was supposed o work in oher words, a srong negaive signal. The non-em counries weden and Norway, by conras, had no such expecaions o begin wih, so he fac ha hey resored o an ineres rae defense carried less of a disappoinmen wih i. Finally, here is a quesion as o he role of capial conrols during he crisis. We know, for example ha pain and Ireland officially insiued some capial conrols during he epember November, 1992, period. In addiion here is some indicaion from, e.g., offshoreonshore ineres differenials ha France imposed implici conrols bu he iming and exen of ha policy is difficul o pin down. Overall here are no enough clear, well-documened capial conrols episodes o accoun explicily for his facor in our esimaions Conclusions 12 Noe however ha he ineres rae defense in Norway was he weakes in he sample. The average differenial o Germany was acually a negaive 1.9%, and Norway s maximum differenial in he sample is only 1.2%. 13 ee Buier e al. (1998) for a deailed discussion of he macroeconomic backdrop leading up o he 1992 crisis, as well as anecdoes showing he rif beween Germany and oher EM members a high-level crisis summis such as he Euromeeing in Bah of epember 5/6, We ried insering a capial conrols dummy in he regressions for pain. The dummy effecively reduced ineres rae expecaions (capial conrols being a subsiue) and increased risk premia (possibly because of he associaed liquidiy issues for, e.g., inernaional speculaors), wih an adverse bu insignifican ne effec overall. We hesiae o make oo much of hese resuls, and do no repor hem, since he dummy is likely endogenous o he amoun of pressure on he pesea and migh jus as well 19

22 In his paper we have considered boh why high ineres may be effecive in deerring speculaion agains a currency and how one may empirically es he effeciveness of he ineres rae defense. We have fleshed ou one explanaion for he effeciveness of high ineres raes in deerring speculaion, namely ha high ineres raes serve as a signal of he governmen s willingness or abiliy o defend he exchange rae. We also presened several ypes of economeric evidence consisen wih he signaling approach. Our key empirical findings are as follows. Firs, he effecs of changes in overnigh ineres raes are clearly non-linear, ofen significanly so, and hese effecs may be eiher concave or convex. This is in conras o he simple arihmeic argumen for he effec of raising ineres raes, bu consisen wih he signaling explanaion (as well as some oher explanaions). econd, here is lile or no clear saisically significan effec of raising ineres raes on nex monh s expeced exchange rae. (Belgium, France, and Ireland show some evidence of an adverse effec.) However, his masks significan effecs on differen componens of +1, +1, and a differen horizons. Cerain regulariies are observed across counries. There are effecs a longer horizons, in conras o wha he simple arihmeic argumen would imply. More specifically, here is some evidence of a posiive (i.e., appreciaing he exchange rae) shor-erm effec, coupled wih a negaive longer-erm effec, a horizons of 12 monhs or longer. In erms of he hree deerminans of nex monh s expeced exchange rae lised in able 1 +1, (ineres raes and risk premia a horizons up o welve monhs, and he welve-monh-ahead exchange rae forecas), an increase in overnigh ineres raes ofen induces an increase in he n- monh ahead rae relaive o he k-monh ahead rae (n > k), hus implying an appreciaion of, bu also an increase in risk premia and, he welve-monh-ahead exchange rae + 1, +12, forecas, implying a depreciaion. We argued ha hese resuls are consisen wih he signaling hypohesis. Firs, he exisence of longer erm, non-linear effecs by iself suggess ha somehing more han he arihmeic effec is a work. The sign of shor-erm ineres rae policy on ineres rae expecaions suggess ha ineres rae increases are aken as a sign of commimen o defend. The deerioraion over longer horizons may indicae ha weak fundamenal are being signaled. As indicaed, some of he resuls are also supporive of oher models. Perhaps he mos simply capure he high poin of he firs crisis wave (saring in epember 1992). 20

23 imporan conclusion ha ess looking a he effec of high ineres raes on summary measures like he oucome of an aack are inconclusive due o offseing effecs, which become clear when one disaggregaes he effecs of raising ineres raes across differen ime horizons and across differen deerminans of shor-erm expeced exchange raes. 21

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