A Double-Edged Sword: High Interest Rates in Capital Control Regimes

Abstract

This paper describes the relationship between central bank interest rates and exchange rates under a capital control regime. Higher interest rates may strengthen the currency by inducing owners of local currency assets not to sell local currency offshore. There is also an effect that goes in the opposite direction: higher interest rates may increase the flow of interest income to foreigners through the current account, making the exchange rate fall. The historical financial crisis in Iceland provides excellent testing grounds for the analysis. Overall, the Icelandic experience does not suggest that cutting interest rates in small steps from a very high level is likely to make a currency depreciate significantly in a capital control regime, but it highlights the importance of effective enforcement of the controls. JEL G01 E42 E52 E58Keywords Financial crises; capital controls; policy rates; exchange rates Authors Gudmundur S. Gudmundsson, Department of Economics and Business, Universitat Pompeu Fabra, Barcelona, Spain Gylfi Zoega, Department of Department of Economics, University of Iceland, Reykjavik, Iceland; Department of Economics, Birkbeck College, London, UK, gz@hi.is Citation Gudmundur S. Gudmundsson and Gylfi Zoega (2016). A Double-Edged Sword: High Interest Rates in Capital Control Regimes. Economics: The Open-Access, Open-Assessment E-Journal, 10 (2016-17): 1-38. http:// dx.doi.org/10.5018/economics-ejournal.ja. www.economics-ejournal.org 2 IntroductionHow should an economy respond to a sudden stop of capital inflows? In particular, how should it combine the use of capital controls and high interest rates when attempting to stem capital outflows? The objective of this paper is to analyze the effect of interest rates in capital control regimes and explore the relationship using data from Iceland's recent financial crisis. Rapid unwinding of the carry trade had disastrous consequences for Iceland in the autumn of 2008 when the exchange rate collapsed, rendering most of the business sector insolvent due to foreign-currency denominated borrowing while the commercial banks suffered a bank run leading to their demise. In such circumstances, countries may resort to capital controls, as did Malaysia in 1998 and Iceland during this episode. 1 This was the measure recommended by the International Monetary Fund. The capital controls that were imposed left the current account open and the conversion of interest income into foreign currency was allowed. 2 More controversially, the IMF recommended that the capital controls be supported by high central bank interest rates, which were raised to 18%.The empirical work on the effect of high interest rates on exchange rates during financial crises does not lend strong support to the argument that high interest rates defend the value of the currency. Caporale et al. (2005) and others find that, while tight monetary policy boosts the exchange rate during normal periods, it weakened it during the Asian crisis in the late 1990s. Goldfajn and Gupta (2003) analyze a...

Do Interest Rates Affect the Exchange Rate Under Capital controls? An event study of Iceland’s experience with capital controls

“…It follows that cutting interest rates from a very high level is not likely to make a currency depreciate in an effective capital control regime, highlighting the importance of the effective enforcement of the controls. The results are consistent with the results of the estimation of a VECM by Gudmundsson and Zoega (2016). This paper ends with the caveat that even if small changes in the Central Bank policy rate do not affect the exchange rate notably in a capital controls regime, interest rate policy can be used to affect aggregate demand, the incentives to save and invest in a balance of payments crisis and the incentive to deleverage.…”

“…Thus domestic interest rates can be lowered without lowering the onshore and the offshore exchange rate. There is also a second effect to consider, as described in a paper by Gudmundsson and Zoega (2016). When trapped foreign investors convert their interest income in domestic currency into foreign currency in the onshore market, the exchange rate will fall.…”

“…Allowing investors to take their interest income out of the currency was meant to prevent the excessive accumulation of domestic currency assets by foreign creditors as well as maintaining credibility in international capital markets. Gudmundsson and Zoega (2016) derive a model of exchange rate determination where the effect of a rise in interest rates on the exchange rate is ambiguous. There are basically two effects that go in opposite directions.…”

“…Finally, Flood and Jeanne (2005) developed a model that demonstrates the difficulty of using interest rate policy to affect exchange rates in a fixed exchange rate regime when fiscal deficits are large, because high interest rates have a negative effect on the public finances and consequently weaken the currency. Gudmundsson and Zoega (2016) study Iceland's experience with capital controls, and estimate a VECM in interest and exchange rates. They find that an interest rate increase makes the currency appreciate, although this effect is weak and barely statistically significant due to the weakness of the coefficient estimates in the VECM.…”