metadata: authors: 0: author: Frankel,Jeffrey A.
1: author: Schmukler,Sergio L.
2: author: Serven,Luis
count: World
docna: 0: docna: Global transmission of interest rates :
            monetary independence and the currency regime
docty: Policy Research Working Paper
subtopic: Consumption,Fiscal & Monetary Policy,Investment and Investment Climate,International Trade and Trade Rules,Inflation,Macroeconomic Management
teratopic: Macroeconomics and Economic Growth,Environment,Finance and Financial Sector Development
abstracts: cdata!: The authors empirically study the
            sensitivity of local interest rates to international
            interest rates and how that sensitivity is affected by a
            country's choice of exchange rate regime. To establish
            the empirical regularities, they use a reduced-form
            empirical approach to compute both panel and single-country
            estimates of interest rate sensitivity for a large sample of
            developing and industrial economies between 1970 and 1999.
            When using the full sample, they find that: 1) Interest
            rates are typically lower in economies with fixed exchange
            rates than in those with flexible exchange rates. 2) More
            rigid currency regimes tend to exhibit higher transmission
            than more flexible regimes. In many cases in the 1990s,
            however, the authors cannot reject full transmission (a
            slope coefficient equal to 1), even for several countries
            with floating regimes. The data suggest an upward time trend
            in the degree to which domestic interest rates are sensitive
            to international capital movements and developing
            economies' increased financial integration with the
            rest of the world. As a result, country-specific estimates
            for the 1990s reveal few cases of less-than-full
            transmission of international interest rates to domestic
            rates, regardless of the currency regime. Country-specific
            results suggest that only large industrial countries can (or
            choose to) benefit from independent monetary policy. During
            the 1990s, interest rates in European countries were fully
            sensitive to German interest rates but insensitive to U.S.
            interest rates.
repnme: repnme: Global transmission of interest rates :
            monetary independence and the currency regime
display_title: Global transmission of interest
            rates : monetary independence and the currency regime
listing_relative_url: /research/2000/08/693335/global-transmission-interest-rates-monetary-independence-currency-regime
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Macroeconomic and Structural Policies
            m1327380 439,Monetary Policy m1327609 444,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Environment,Finance and Financial Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 40
author_keys: 0: author_key: 435764
1: author_key: 142794
2: author_key: 93728
model_extractions: **POLICY RESEARCH WORKING PAPER** 2424

# **Summary findings**

Frankel, Schmukler, and Serv6n empirically study the sensitivity of local interest rates to international interest rates and how that sensitivity is affected **by** a country's choice of exchange rate regime.

To establish the empirical regularities, they use a reduced-form empirical approach to compute both panel and single-country estimates of interest rate sensitivity for a large sample of developing and industrial economies between **1970** and **1999.** When using the full sample, they find that:

* Interest rates are typically lower in economies with fixed exchange rates than in those with flexible exchange rates.

* More rigid currency regimes tend to exhibit higher transmission than more flexible regimes.

In many cases in the 1990s, however, the authors cannot reject full transmission (a slope coefficient equal to **1),** even for several countries with floating regimes. The data suggest an upward time trend in the degree to which domestic interest rates are sensitive to international capital movements and developing economies increased financial integration with the rest of the world.

As a result, country-specific estimates for the 1990s reveal few cases of less-than-full transmission of international interest rates to domestic rates, regardless of the currency regime.

Country-specific results suggest that only large industrial countries can (or choose to) benefit from independent monetary policy. During the 1990s, interest rates in European countries were fully sensitive to German interest rates but insensitive to **U.S.** interest rates.

This paper-a joint product of Macroeconomics and Growth, Development Research Group,<sup>and the ChiefEconomist</sup> Unit, Latin America and the Caribbean Region-is part of a larger effort in the<sup>Banktounderstandthefunctioningof</sup> alternative currency arrangements. Copies of the paper are available free from the World<sup>Bank,</sup><sup>**1818**HStreet NW,</sup> Washington, **DC** 20433. Please contact Emily Khine, room **MC3-347,** telephone **202-473-7471,** fax<sup>**202-522-3518,**email</sup> address kkhine@worldbank.org. Policy Research Working Papers are also posted on the Web at www.worldbank.org research/workingpapers. The authors may be contacted at jeffrey_frankel@harvard.edu, sschmukler@worldbank.org,<sup>or</sup> lserven@worldbank.org. August 2000. **(33** pages)

> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage_<sup>_theexchange of ideas ahout_</sup> _development issues. An ohjective ofthe series is to get the findings out quickly, even ifthe Presentations are less than_<sup>_fully_</sup> _polished._<sup>_The_</sup> _papers carry the names of the authors and should he cited accordingly. The findings, interpretations, and conclusions_<sup>_expressed inthis_</sup> _paper are entirely those of the authors. They do not necessarily represent the view of the World Bank,_<sup>_its_</sup> _Executive_<sup>_Directors, or the_</sup> _countries they represent._

**Produced by the Policy Research Dissemination Center**
# **Global Transmission of Interest Rates: Monetary Independence and Currency Regime**<sup>**4**</sup>

Jeffrey Frankel _Harvard University and NBER_ Sergio Schmukler _World Bank_ Luis Serv6n _World Bank_

## **JEL Classification Codes: F3 1, F32, F33, F36**

**Keywords: interest** rates, exchange rate regime, currency regime, monetary independence, monetary policy

We thank Jorge Streb and participants at the June 2000 conference on Currency Regimes, www.worldbank.org/lacconferences, for very useful comments. We are grateful to Andrea Bubula, Eduardo Fajnzylber, Changqing Sun, Nong Thaicharoen, and Hairong Yu for excellent research assistance. We also thank Atish Ghosh and Holger Wolf for generously providing us with their data. The World Bank **LAC** Regional Studies Program provided financial support for this research. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.

E-mail addresses: jeffrey frankelPharvard.edu, sschmukler@Aworldbank.org, lserven@worldbank.org
# **1. Introduction**

As has also been true in past episodes of global monetary tightening, **1999-2000** hikes in **U.S.** interest rates were rapidly reflected in interest rate increases in other industrial and developing economies. In emerging markets, the increases were in several cases proportionally larger than those experienced in the **US,** presumably because country and/or currency risks increased after the Fed decided to tighten **US** monetary policy. Even though the pressure to increase interest rates was felt virtually across the board, one question remains unanswered: are countries with flexible exchange rates more able to isolate their domestic interest rates from this type of negative international shock? This issue of monetary independence, which lies at the heart of the debate on currency arrangements, is the central question of this paper.

The choice of exchange rate regime-floating, fixed, or somewhere in betweenhas been a recurrent question in international monetary economics. According to the conventional view, the two major advantages of fixing the exchange rate are: **(1)** reduced transactions costs and exchange rate risk, that can discourage trade and investment, and (2) a credible nominal anchor for monetary policy.

The advantages of a flexible exchange rate, on the other hand, can generally be described under one major property: it allows the country to pursue independent monetary policy. The argument in favor of monetary independence, instead of constraining monetary policy **by** the fixed exchange rate, is the classic argument for discretion instead of rules. When the economy is hit **by** a disturbance, such as a shift in

> To be sure, other factors enter as well. Two other advantages of an independent currency are that the government retains seignorage, and floating allows smooth adjustment to real shocks even in the

> presence of price frictions. Most of the important factors, however, can be lumped into the major arguments presented in the text.

1
worldwide demand away from the goods it produces, the government would like to be able to respond, so that the country does not go into recession. Under fixed exchange rates, monetary policy is always diverted, at least to some extent, to dealing with the balance of payments. Under the combination of fixed exchange rates and complete integration of financial markets, which characterizes the European monetary union, monetary policy becomes completely powerless. **By** freeing up the currency, on the other hand, the country can respond to a recession **by** means of monetary expansion and depreciation of the currency. This stimulates demand for domestic products and returns the economy to desired levels of employment and output, more rapidly than would be the case under the automatic mechanisms of adjustment on which a fixed-rate country must rely.<sup>3</sup> According to the traditional arguments, under pegged exchange rates and unrestricted capital flows, domestic interest rates cannot be set independently, but rather must track closely those prevailing in the country to which the domestic currency is pegged. **By** contrast, under a flexible exchange rate arrangement, the domestic interest rate should be less sensitive to changes in international interest rates--other things equal. Countries.with intermediate regimes should also display less sensitivity to international interest rates than countries with firm pegs.

However, an alternative view-stated, among others, **by** Calvo and Reinhart (2000a and **2000b)** and Hausmann, Panizza, and Stein (2000)-holds that there exists

> 2 An expansion in the money supply has no effect: the new money flows out of the country, via a balance of payments deficit, just as quickly as it is created. In the face of an adverse disturbance, the country must simply live with the effects. After a fall in demand, for example, the recession may last until wages and prices are bid down, or until some other automatic mechanism of adjustment takes hold.

> For a more complete exposition of the advantages and disadvantages of alternative exchange rate regimes, see Frankel, Schmukler, and Serv6n (2000).

2
> "fear of floating," that prevents countries with _de jure_ flexible regimes from allowing their exchange rates to move freely. According to this view, factors like lack of credibility, exchange rate pass-through, and foreign-currency liabilities prevent countries

> from pursuing an independent monetary policy, regardless of their announced regime. Therefore, many countries, even if formally floating, are _de facto_ "importing" the monetary policy of major-currency countries, much as those with pegs.

Although monetary independence has been at the heart of the debate on exchange rate regimes, empirical evidence on the issue is still scarce. In particular, there are few empirical studies on whether floating exchange rate regimes do indeed allow independent monetary policy, in the sense that interest rates in countries with floating regimes are less sensitive to foreign interest rates. Focusing on currency boards and some floating regimes, Borensztein and Zettlemeyer (2000) find some evidence consistent with the traditional view. On the other hand, selected country evidence during the 1990sreported in Frankel **(1999)** and Hausmann, Gavin, Pages, and Stein **(1** 999)-is consistent with the alternative view.

> The goal of this paper is to establish the major empirical regularities concerning

> the sensitivity of domestic interest rates to international interest rates under different currency regimes. To do this, we analyze existing experiences from the widest possible

> spectrum of regimes, from full exchange rate flexibility to currency boards. Thus, the paper should help place the ongoing debate in the context of the observed facts, and allow

**3**
an assessment of the competing claims cited above<sup>on therelativemeritsof alternative</sup> exchange rate arrangements from the perspective<sup>of monetaryindependence.4</sup> The paper extends the empirical literature<sup>inseveraldirections.First,while</sup> previous studies have been limited to a handful of<sup>countriesover short time periods,here</sup> we consider a much larger data set in both the cross-country and time-series dimensions, **by** working with a sample of<sup>industrial anddevelopingcountriesoverthelastthree</sup> decades. Second, we test the robustness of the results<sup>tochangesinsample coverage.</sup> We present estimates both.for the overall sample<sup>as wellassubsamplesof industrialand</sup> developing countries and different time periods.<sup>Third,todealwiththe inaccuraciesof</sup> standard exchange rate regime classifications,<sup>wealsopresentempiricalresultsfor</sup> selected countries, whose exchange arrangements<sup>aregenerallyregardedasmoreclear-</sup> cut than the rest. Finally, even though<sup>we workmainlywith</sup><sup>**US**ratesasourprimary</sup> indicator of "foreign interest rates," we<sup>alsotake intoaccounttheemergenceinrecent</sup> years of other currency areas, most<sup>notablytheDeutschemark-European Monetary</sup> Union **(DM-EMU)** zone. Thus, we examine<sup>thesensitivityof Europeaninterestratesto</sup> German interest rates.

The rest of the paper is organized as<sup>follows.</sup> Section 2 introduces the methodology and data used in this paper. Section **3**<sup>presentspooled estimationresults</sup><sup>**by**</sup> exchange rate regime, income group, and<sup>decade. Section4takesacloserlookatthe</sup> evidence from individual countries.<sup>Section</sup><sup>**_5_**summarizestheresults andconcludes.</sup> The Appendix describes the exchange rate<sup>regimesin eachcountryin the sample.</sup>

> 4 There is an extensive literature that studies the merits<sup>ofdifferentexchangerateregimesin other</sup> dimensions. For example, Ghosh, Gulde, Ostry,<sup>andWolf</sup><sup>**(1996)**analyzethebehaviorofinflation</sup> and growth under alternative exchange rate arrangements.

_4_
# 2. Methodology and Data

> In principle, there are several factors that determine the extent to which domestic

> and foreign interest rates move together. The first one is the degree of financial

> integration of the domestic economy into world markets. For example, as described in Kaminsky and Schmukler (2000), barriers to international capital flows can dampen the

> response of local interest to changes in international rates. Second, the degree of _real_ international integration also matters for the comovement of domestic and foreign interest rates-if business cycles are **highly** synchronized across countries, domestic and foreign rates will tend to move closely together, given other things. Third, the nature of shocks

> also contributes to determine the degree of comovement. Unlike country-specific idiosyncratic shocks, common shocks-such as financial and climatic-affect many

> countries simultaneously, what tends to be reflected in closer correlation of interest rates,

> for given degrees of international real and financial integration.

Our primary concern here, however, is to establish the empirical regularities regarding the overall link between local and foreign interest rates, rather than sorting out the role of each of the above factors. Thus, we focus on the estimation of a simple reduced-form specification of the type

> where _i_ = **_1.N_** and t = _1.T._ Here ri represents the domestic nominal interest rate in

> local currency of country _i_ at time t;fi is a country-specific effect;5 r, is the international interest rate; and _X,,_ is a set of control variables. We assume that the error term **et,,** has

**_5_**
mean zero and is independently distributed across countries, but is possibly heteroskedastic and serially correlated.

We experimented with two sets of control variables _X,._ The first one includes only the difference between the domestic and foreign inflation<sup>rates.6Wedo this because</sup> much of the variation in nominal interest rates across countries<sup>and overtimemay just</sup> reflect variation in inflation rates, which is quite substantial in<sup>oursample.</sup> Next, we added into _X,_ a set of dummy variables to control for turbulent periods, when the sensitivity of local interest rates to foreign ones may differ<sup>fromits"normal"</sup> value. Specifically, we used three dummies. The first<sup>oneisa"crisis"dummythat,</sup> following the literature on exchange rate crises, takes a value of one<sup>when the cumulative</sup> depreciation of the nominal exchange rate over a three-month<sup>period is equaltoor greater</sup> than **15** percent. The second is a hyperinflation dummy that takes<sup>avalueof one when</sup> monthly inflation is above **50** percent, and zero otherwise. Finally, the third is a "transition" dummy to control for changes in the exchange rate regime-specifically,<sup>exit</sup> from pegs to other regimes. Since such exits tend to be accompanied<sup>**by**considerable</sup> financial turbulence, in the absence of controls the new<sup>regimemaybe unduly associated</sup> with higher or more volatile interest rates and inflation,<sup>amongotherthings.7</sup> The transition dummy takes a value of one in the month of the transition<sup>aswellasthose</sup>

> Note that time specific effects cannot be included, because they would be perfectly collinear with r, **.**

> **6 All** interest rates and inflation rates x are defined as _In_ **_(1_** +x). We also experimented with a somewhat more general version including separately domestic and foreign inflation,<sup>rather than entering them as</sup> a differential. Results with this broader specification, however, showed that in general<sup>the differential</sup> specification was not rejected **by** the data.

This is noted, for example, **by** Edwards and Savastano **(1999).**

**6**
immediately preceding and following it.<sup>8</sup> To allow some additional flexibility in our specification, we also interacted the three dummies with the foreign interest rate. On the whole, the empirical results obtained including the dummies were quite similar to those from the specification with inflation alone, and hence to save space we only report the latter below.<sup>9</sup>

> We estimate equation **(1)** separately for each currency regime, since preliminary

> evidence showed that neither the country effects nor the coefficients on the control variables were equal across regimes. For each regime, we are interested in two parameters, characterizing respectively the sensitivity of the local interest rate to the foreign rate **(P3** in equation **(1)** above), and the average level of the local interest rate after controlling for the other factors. The latter can be summarized **by** a parameter cx, defined as:

that is, the average of the country-specific effects under the regime in question.'o We present two types of estimates. In section 4, we report pooled fixed-effect estimates, combining all the available information as well as grouping countries **by** income level and breaking the sample **by** decade (1970s, 1980s, and 1990s), to see if

> **8** We also experimented with other specifications enlarging the transition period and dropping the corresponding observations. Likewise, we used different variations on our crisis dummy-working with higher and lower depreciation thresholds and periods. These alternative specifications had only a

> modest impact on the parameters of interest.

> Those results are available upon request and downloadable from www.worldbank.org/Iacconferences.

> **10** Strictly speaking, this definition would apply if under each exchange rate regime all countries possessed

> the same number of time-series observations. In practice, this is not the case because our panel is heavily unbalanced. The formula then is amended using weights given **by** the respective number of observations.

**7**
there are any significant differences along these dimensions. In section **_5,_** we report country-specific estimates, for which **_N =_** 1 and hence the level parameter a is just the regression constant.

According to conventional wisdom, more flexible exchange rate regimes should allow countries additional room to pursue their independent monetary policy. Therefore, the sensitivity to international interest rates should increase with the rigidity of the exchange rate regime. In other words, for a given degree of capital mobility, real integration, and other factors, we would expect Ofixed) Pintermediate) Pfloating. In fact, in a fixed exchange rate regime with full capital mobility we should expect **fixed = 1.** At the opposite extreme, if domestic monetary policy is completely independent, we would expect Pfloating = **0 .** In that case, the exchange rate bears the burden of absorbing the shocks to international interest rates. However, it is more common for countries to pursue "dirty floating" arrangements under which they usually intervene in foreign exchange markets, and in those cases we should find managed floating)<sup>0</sup> .

In turn, the country-specific effect **_f_** measures, for each country and under each regime, the average level of the interest rate not accounted for **by** foreign interest rates and the inflation differential. Hence, it may be viewed as reflecting the mean level of currency risk and country risk not captured **by** other variables. The average of the country-specific effects under each regime (a as defined earlier) can then be viewed as a measure of the regime's mean currency risk plus country risk. Thus, if for example more rigidly fixed exchange rate regimes reduce devaluation expectations, for given country risk perceptions, we should obtain afixd **(aintermediate** (afloating.

**8**
# **2.1 Data**

> Our basic source of interest rate data is the International Financial Statistics of the IMF. We work with monthly data on local money market rates for the 1970s, 1980s, and

> 1990s. We choose money market interest rates because they reflect market forces better

> than deposit rates. The latter, while much more widely available, are often subject to administrative controls and in many cases display little movement over prolonged

> periods, which renders them uninformative for our purposes." When available, we choose the 90-day money market rate; otherwise, we use the 30-day rate. As international interest rate, we use the 90-day **US** T-bill rate. 12 Finally, for some experiments below, we use also the German 90-day T-bill rate.

The classification of exchange rate regimes is taken from the IMF. The Appendix lists the regime prevailing in each country over the sample period according to this source. The classification used here is based on a quarterly database from the IMF on exchange rate regimes encompassing a total of **10** categories, based on officially reported exchange arrangement for the period **1975-1996;** see the Appendix for more details. We present some empirical results (in Table 1 below) from estimating equation **(1)** using the detailed regime categories in the original source. However, to facilitate our analysis, in the rest of our experiments we condense these categories into three broader exchange rate

> In a number of cases we found that the money market interest rate data from **IFS** were identical to the deposit data. In such cases, we discarded countries/periods for which rates showed no variation or

> infrequent step-wise movements.

> 12 We also experimented with the LIBOR **US** dollar rate. The results were very similar, since the two rates are very **highly** correlated

**9**
regimes: fixed (pegs), intermediate (limited flexibility, crawls, bands, managed floating), and flexible (free-floating). **13** The rest of our data-exchange rates, inflation, and country indicators, such as population and income level on which the sample selection is based-come<sup>from the</sup> World Bank-IMF databases.

We focus on industrial economies and middle-income developing countries. Within this broad group, sample coverage is dictated **by** the availability of<sup>adequate</sup> interest rate data.'<sup>4</sup> The sample that results comprises 47 countries **(18** industrial and **29** developing) in addition to the **US,** whose interest rate is used as an explanatory variable, and a total number of monthly observations exceeding 9,400.

# **3.** Interest Rate Sensitivity: Pooled Estimates

We first assess empirically the sensitivity of domestic interest rates to **US** interest rates **by** estimating equation **(1)** using the entire sample, as well as distinguishing between industrial and developing countries and considering subsamples defined<sup>**by**time</sup> period.

Table 1 presents the full-sample fixed-effects estimation results, using a fiveregime classification of currency arrangements. To avoid cluttering the table,<sup>here andin</sup> the rest of the paper we only report the coefficients of interest-i.e., the slope parameter

> **13** As a robustness check, we compared the results obtained with this condensed classification with those obtained using the classification of Ghosh et al. **(1996).** On the whole, the results were very similar.

> 14 We dropped country/regime episodes possessing less than one year of consecutive monthly observations. We also excluded countries with population under one million, countries without availability of long exchange rate series (which automatically leads to the exclusion of Eastern European economies), low income countries (in which the incidence of interest rate controls is more widespread), and countries with prolonged internal or external war periods.

**10**
**3** and the level parameter ox defined earlier-and omit the estimated coefficients on the inflation differential and the individual country-regime fixed effects.

The top line of Table **1** shows that for the entire sample, taken as a whole, the sensitivity of domestic to foreign rates is 0.76-and not significantly different from one at conventional significance levels. The rest of the table shows the results obtained estimating separate panels **by** exchange rate regime. Taken at face value, the pattern of slope coefficients that emerges across regimes seems to conform to conventional wisdom: it is highest (at **0.76)** in the pegged regimes-followed **by** the intermediate regimes at **_0.55._** Interestingly, there seems to be little difference whether the peg is to the **US** dollar or to other currencies. Floating regimes show the lowest interest sensitivity at **0.27.** In fact, for the pure and managed floating regimes, the slope coefficient is estimated imprecisely and is not significantly different from zero.

> The estimated constants under each regime also deserve mention. As noted

> earlier, they could be viewed as reflecting the level of the domestic interest rate

> characteristic of each regime, after removing the effects of inflation and international interest rates. The table shows that, given other things, the level of local interest rates is

> lowest under fixed exchange rate arrangements." At the other extreme, floating and managed floating regimes tend to exhibit the highest interest rate levels, given other factors.

> In spite of the simplicity of our empirical specifications, they capture a fair

> amount of the observed variation in interest rates, as shown **by** the total and within R<sup>2</sup>

> 15 Actually, the level estimate is lowest for pegs to currencies other than the dollar. This might reflect the

> fact that during the sample period these currencies had, on average, lower interest rates than the ones pegged to the **US** dollar.

11
statistics in the table. (The within R<sup>2</sup> excludes the portion of the fit attributable to the specific effects.) Thus, pooling all countries and all time periods, the results seem to support the traditional view, according to which interest rates from more flexible currency regimes are less sensitive to foreign interest rates. We next investigate whether this result holds when we partition the sample **by** income level and time period. To keep the amount of information manageable, we proceed in the same fashion as Ghosh et al. **(1999)** and condense the various exchange rate regimes into only three broader categories: fixed, intermediate, and floating.

Table 2 divides the sample between industrial and developing countries. For the entire sample of developing countries, the slope estimate is close to one (although not very precise); while for industrial economies it is just above **0.62** and significantly different from unity. As before, however, there are important differences across regimes. In both subsamples, the largest slope coefficient corresponds to the pegged regimesclose to unity in the industrial countries, but considerably lower in the developing countries. In the industrial economies, the intermediate regimes exhibit the least sensitivity to foreign interest rates. In the developing countries, no clear conclusion can be drawn since the slope estimate under floating is **highly** imprecise (and negative). Interestingly, slope estimates are uniformly lower in the developing country sample, regardless of regime. Rather than implying that developing countries enjoy more monetary independence than industrial ones under any regime, the likely explanation for this result is that, over the full 30-year sample period, developing economies were on 12
average less integrated than industrial economies into world financial markets and their interest rates are determined less freely in the market.

Finally, the regime constants show a pattern opposite to that of the slope estimates: for each regime, they are larger in the developing country sample than in the industrial country sample. The difference is particularly striking in the case of floating regimes. This suggests that, other things equal, developing countries tend to exhibit higher interest rates than industrial countries. Across regimes, the same pattern found in Table **I** holds for both developing and industrial countries: the constant is lowest in pegged regimes than in the rest.

> The above results are open to question, however, because the long time span of the full sample may conceal significant variation over time in the sensitivity of domestic

> to foreign interest rates, as barriers to international capital movements have declined steadily over the last two decades. To explore this, Tables **3** and 4 further disaggregate

> the samples of developing and industrial countries **by** decade. Table **3** presents the results for developing countries **by** decade and regime. It is apparent from the table that

> our slope estimates under floating regimes are very poor in all three decades of available data-the point estimates are negative and exhibit large standard errors. Leaving floating regimes aside, the table does suggest an upward trend in the estimated slope coefficients across decades, both for fixed and intermediate regimes. In the 1990s, both fixed and intermediate regimes exhibit a high degree of sensitivity to foreign interest rates, with

> slope coefficients not significantly different from unity.

Table 4 presents the same information as the previous table for industrial economies. It is important to note that the industrial country sample does not include any

**13**
fixed regimes after the 1970s; hence the fixed exchange rate results for the 1970s<sup>are</sup> just those shown in Table 2 above for the entire sample period, and they<sup>reveal</sup><sup>**full**</sup> transmission of international interest rates. In the 1970s and 1980s, there is little difference between the slope estimates of intermediate and floating<sup>regimes,withthe</sup> former slightly larger than the latter. In the 1990s, however, the result is reversed: floating regimes show a slope estimate very close to one, while for intermediate<sup>regimes</sup> we obtain a puzzling slope estimate, small and not different<sup>from zero.</sup> To summarize this section, a naive look at our full-sample results would<sup>seemto</sup> lend support to the conventional wisdom that fixed exchange rate regimes<sup>show greater</sup> sensitivity of domestic to foreign interest rates than the other regimes.<sup>Inaddition,fixed</sup> regimes also tend to exhibit lower average interest rates after<sup>otherfactorshavebeen</sup> taken into account. Using the full sample period, we also find that in general the sensitivity of domestic interest rates to foreign rates appears higher<sup>inindustrialthanin</sup> developing countries, a result suggestive of the more limited financial<sup>integrationof the</sup> latter economies over the sample period.

When looking at the results in more detail, however, the conventional<sup>wisdom</sup> fares less well, and some puzzles emerge. First, among developing<sup>economies, boththe</sup> fixed and intermediate regimes appear to exhibit full transmission of<sup>foreigninterest rates</sup> in the 1990s. In contrast, the pooled data do not yield any sensible slope<sup>estimatesfor the</sup> developing-country floating regimes. Second, among industrial countries, the<sup>floating</sup> regimes also exhibit full transmission in the 1990s, while intermediate<sup>regimesdisplayan</sup> awkward pattern, with their slope estimate declining to nearly zero in the 1990s.<sup>This</sup> latter result is puzzling, because it appears to run counter the worldwide trend<sup>towards</sup> 14
> increasing financial integration. It is worth noting that the **EMU** group accounts for the

> bulk of countries under this regime in the 1990s, and this raises the question of whether

> **US** interest rates-rather than, say, German interest rates-really provide the right

> measure of external financial conditions for this group of countries.

> In summary, there are clear discrepancies between the pooled estimates from the

> full sample and those obtained from the income and period-based subsamples, In

> addition, the results using pooled data may also suffer from limitations related to the

> accuracy of the underlying regime classification, as well as the more general concern of heterogeneity across countries-which the pooled estimates limit to the relatively trivial

> dimension of country-specific constants. To assess the relevance of these concerns, we next turn to country-specific estimation.

# 4. Interest Rate Sensitivity: Heterogeneous Estimates

> To avoid possible heterogeneity biases that might be present in the pooled

> estimates of the previous section, here we focus on individual-country estimates of equation **(1).** Further, we focus on a few selected countries whose exchange rate regime can be categorized in a relatively straightforward manner, in order to avoid the risks of

> misclassification that arise when using a large number of countries. Also, we limit our attention to the 1990s, where the puzzles mentioned above appear more evident.

> Table **_5_** presents estimation results for **10** developing countries, grouped in the

> following three regime categories. Hard pegs (currency boards) consist of Argentina and Hong Kong. Intermediate regimes (including currency bands, managed floats, and

> similar arrangements) involve Chile, Indonesia, Israel, Singapore, and Thailand. Free-

**_15_**
floating regimes comprise Mexico after the Tequila crisis, Philippines, and South Africa.'<sup>6</sup> In addition to the point estimates and their standard errors, the table also reports the p-values from the test of the null hypothesis that the slope coefficient equals one (i.e., full sensitivity of domestic interest rates to foreign interest rates).

The first two rows of Table **_5_** report the estimates for the "hard pegs" of Argentina and Hong Kong. The point estimates of the slope coefficient are close to one, although the estimate for Argentina is rather imprecise. The next block in Table **_5_** reports the results for the intermediate regimes. Here all the slope estimates are statistically different from zero, and several of them are actually larger than one.'<sup>7</sup> In fact, we cannot reject the hypothesis that **US** interest rate changes are fully reflected in local rates for any of the countries in the table.

The last block in the table presents the floating regimes, which yielded implausible slope estimates in the pooled regressions of the previous section. For Mexico, this continues to be the case in Table **_5._** The point estimate is large, negative and very imprecise, a likely reflection of the financial turbulence following the Tequila crisis that resulted in skyrocketing domestic interest rates at a time when they were declining in the **US.** For the Philippines, in contrast, we find a high slope coefficient, above unity. Finally, for South Africa the slope coefficient exceeds one at standard confidence

> In a number of instances the residuals display serial correlation; rather than differencing the data and losing potentially valuable information, we report Newey-West standard errors robust to both heteroskedasticity and autocorrelation. We set the number of lags for the Newey-West covariance matrix computation at three. Results with other lag specifications were similar in most instances.

> **17** Whenever data permitted, we also computed country-specific estimates for an extended sample period, which we do not report to save space. With very few exceptions, the estimates for the 1990s reported here were generally larger than those calculated with longer samples, suggesting an upward time trend in the degree of interest rate transmission.

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levels.'<sup>8</sup> The pattern of the estimated constants across regimes is also reminiscent of that found in the previous section: they are generally higher in the floating regimes<sup>thanin the</sup> rest.

On the whole, therefore, the developing country estimates do not show much difference across exchange regimes regarding the sensitivity of local interest<sup>rates</sup> to foreign ones. In most cases the estimates are consistent with the hypothesis of full transmission of foreign interest rate disturbances, regardless of exchange regime.<sup>One</sup> important exception is Mexico, where the estimates are too imprecise to permit any firm conclusion. In the rest of cases, however, the data suggest that the slope coefficients<sup>are</sup> equal to or greater than one in the 1990s.

We now turn to the industrial countries. The pooled estimates from the<sup>previous</sup> section revealed two surprising facts. First, intermediate regimes<sup>appearedtoexhibita</sup> declining sensitivity to foreign interest rates, which became practically negligible<sup>inthe</sup> 1990s. Second, floating regimes showed the opposite trend, with their slope coefficient becoming equal to one in the 1990s. We next explore these two issues in more depth.

Concerning the first puzzle, it is important to note that European countries account for the bulk of the intermediate regimes in the 1990s. Country-specific estimates, which we do not report here to save space, confirm the findings from the pooled regression, namely that the sensitivity of local rates to **US** T-Bill rates falls abruptly in the 1990s. As noted earlier, however, most of these countries have in fact belonged to the DM (now **EMU)** area for quite a few years, and it is unclear whether **US** rates provide the right measure of "foreign interest rates" for them.

> **18** South Africa's multiple exchange rate regime was unified in **1995.**

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> To illustrate this fact, Table **6** presents estimation results for six of these

> economies using the German T-bill interest rate rather than the **US** T-bill rate as explanatory variable. The results are revealing. The slope estimates are all **highly**

> significant (with the exception of Italy in the 1990s, whose available sample is very

> short). The slope coefficients actually exceed one-significantly so in all cases except

> Belgium.19 Thus, the declining pattern of the slope coefficients found in the pooled estimates is not a reflection of increased monetary independence but, on the contrary, a straightforward consequence of the fact that these countries have de-linked themselves from the **US** dollar area to become tightly linked with the DM.

Finally, we turn to the industrial-country floating regimes. Table **7** reports regression results for three large economies (Germany,<sup>20</sup> Japan, and the **UK)** and three smaller ones (Australia, New Zealand, and Canada). The table shows a striking contrast between the two groups. The three smaller economies exhibit large slope coefficients exceeding one-significantly so in Australia and New Zealand. Further, the explanatory power of the estimated equations is fairly high. The larger economies, in turn, all possess slope coefficients below one. For both the **U.K.** and Germany, the estimate for the 1990s is insignificantly different from zero and significantly different from one. In turn, Japan has the highest slope coefficient in this group **(0.73).** It is not significantly different from one, although its precision is relatively low.<sup>2</sup> 1 Again in contrast with the smaller

> 19

> Again, if one uses longer sample periods (starting in the 1970s and 1980s), the slope coefficients turn smaller-showing an increasing pattern over time, as the **EMU** area consolidated.

> 20 Germany obviously does not float vis-A-vis her EMU partners, but can be viewed as floating vis-i-vis the **US** dollar.

> 21 Japan's full-sample estimate under floating (corresponding to the years **1973-99)** is **0.65,** numerically similar to that obtained in the 1990s, but its precision is much higher (a standard error of **0.09), so** that _it can_ be safely viewed as smaller than one.

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economies, the explanatory power of the empirical equations<sup>isquite poorforthe three</sup> large floating-regime economies.

To summarize this section, the closer inspection of individual country data confirms some of the findings from the pooled<sup>regressions,andalsohelpssolve someof</sup> the puzzles they posed. On the whole,<sup>wefindlittleevidenceinthe1990sagainstthe</sup> hypothesis of full transmission of foreign interest rate disturbances into domestic rates, regardless of exchange regime and income level. On the<sup>contrary,slopecoefficients tend</sup> to exceed one in several industrial and developing<sup>countries</sup> There are exceptions, however. Most notably, large industrial countries with floating regimes (Germany and the **UK)** exhibit slope coefficients<sup>wellbelow unity.This</sup> suggests that large industrial countries may be the only economies<sup>thattrulypossess,or</sup> make use of, monetary independence.

# **5.** Conclusions

In this paper we have tested whether the transmission of<sup>international interestrate</sup> changes to local rates is affected **by** the exchange rate regime.<sup>Thisisanimportant</sup> question in the context of the debate on the choice of currency regime,<sup>inwhichthe issue</sup> of monetary independence has played a central role. Proponents of free-floating arrangements have argued that countries adopting floating regimes would be able to pursue their own monetary policy goals, while advocates of hard pegs have<sup>questioned</sup> the feasibility of such a strategy in a world of high international capital mobility.

The paper has taken a first step towards assessing empirically the relative merits of these two views, **by** reviewing the empirical regularities on international interest rate

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> linkages for a large sample of industrial and developing countries. The approach taken

> here extends and generalizes earlier studies that have focused on a small group of countries over brief time periods. Specifically, the paper has examined the evidence from industrial and developing countries over the last three decades, using both pooled and single-country empirical estimates. The objective is to establish the main stylized facts that will need to be addressed in the debate on monetary independence and the choice of currency regime. To do this, we have employed simple reduced-form specifications relating domestic to world interest rates. In spite of their simplicity, the empirical models capture a large proportion of the variance in local interest rates, within and across countries.

> The main result of the paper is that over the last decade all exchange rate regimes exhibit high sensitivity of local interest rates to international ones. Indeed, in the 1990s

> we find very few instances of less-than-full transmission (i.e., a slope coefficient significantly smaller than one), regardless of exchange rate regime. This result emerges both from the country-specific estimates and from close inspection of the pooled estimates.

> The main exception to this rule is provided **by** a few large industrial countries, which according to the evidence in the paper appear to be the only ones that can or choose to benefit from independent monetary policy. Specifically, the slope coefficients for Germany and the UK-large economies with floating regimes vis-A-vis the US-are statistically smaller than one. In contrast, in other industrial countries, including smaller economies with floating regimes (Australia, Canada, and New Zealand), local interest

20
rates **fully** reflect **US** rates. Among developing-country<sup>floatingregimes,theresultsare</sup> somewhat noisier.

Interestingly, during the 1990s, interest<sup>rates inEuropean countrieshavebecome</sup> virtually insensitive to **US** interest rates-but<sup>fullysensitivetoGermaninterestrates.</sup> Thus, European countries have shifted from<sup>the</sup><sup>**US**monetary area to the</sup><sup>**DM-EMU**</sup> monetary area between the 1970s and 1990s,<sup>andthedeclineinthe responsivenessof</sup> their interest rates to **US** interest rates does<sup>notsignify anyincreaseintheirdegreeof</sup> monetary independence.

It is important to note that the finding of<sup>completetransmissionismaskedin the</sup> full-sample pooled estimates, which taken<sup>atfacevaluewould appeartosupportthe</sup> conventional wisdom-that fixed currency regimes<sup>tendtoexhibithigher transmission</sup> than more flexible regimes. The main reason is that the<sup>longtimespanof thefull sample</sup> **(30** years) mixes periods characterized<sup>**by**verydifferent degreesofinterestrate</sup> transmission. Indeed, the data suggest an upward<sup>timetrendinthedegreeof sensitivity</sup> of domestic to foreign interest rates, consistent<sup>withthegradualremovalof barriersto</sup> international capital movements and the increased<sup>financialintegrationofdeveloping</sup> economies with the rest of the world.

Finally, our pooled results suggest that interest<sup>ratesarein most instanceslower in</sup> countries with fixed exchange rate regimes. The<sup>differenceappearsparticularlylargein</sup> developing countries.

To conclude, the empirical regularities identified<sup>inthepaperleavemany</sup> questions open for future research. We shall mention three. The<sup>firstoneconcernsthe</sup> interpretation of our finding of full transmission in<sup>the1990s, infixedandflexible</sup> 21
regimes alike, except for large industrial economies. Does this mean that floating-regime countries are not able to pursue their independent monetary policy, or rather that they choose not to float, perhaps due to fear of floating?

Related to this, what is the role of financial integration in the increasing degree of interest rate transmission shown **by** the data? The "Impossible Trinity" principle states that countries can choose two of the following three: capital mobility, monetary policy, and exchange rate flexibility. However, the fact that we found virtually full transmission in the 1990s seems to imply that financial integration might be playing a bigger role than the above principle suggests.

Finally, the paper has not explored the channels through which international interest rates are transmitted to domestic rates, nor the dynamics of the transmission process. For example, to understand better the determinants of the degree of transmission, it would be useful to explore separately the impact of international rates on country risk premium and currency premium. This is the subject of ongoing research.

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# **Appendix: Exchange Rate Regime Classification**

The starting point is the IMF's quarterly database on exchange rate regimes, which encompasses a total of **10** categories, based on officially reported exchange arrangements for the period **1975-1996.** We transform the IMF database to a monthly basis, complementing the original source with information contained in Cottarelli and Giannini **(1997).** Finally, the classification is extended until March **1999,** using information from IMF reports and publications, including the Exchange Rate Arrangements and Restrictions and the International Finance Statistics, **1998** and **1999.** For the countries used in the individualcountry estimates, we extend the classification until December **1999.** In addition to the original classification, we construct new categories to account for the specific currency to which some fixed regimes are pegged.

For most experiments in the paper, we condense the ten categories in the original source into three broader exchange rate regimes: fixed (pegs), intermediate (limited flexibility, crawls, bands, managed floating), and flexible (free-floating). Specifically, pegged regimes include: peg to the **US** dollar, peg to the French franc, peg to other currencies (comprising Indian rupee, South African rand, British pound, and Deutsche mark), peg to SDR (IMF basket), and basket pegs (including the so-called Bretton Woods basket peg). In turn, intermediate regimes include: limited flexibility with respect to a basket, limited flexibility with respect to a single currency, limited flexibility with respect to a cooperative arrangement (including the European Monetary System), managed floating, crawling pegs, and crawling bands. The full details are given in the Appendix Table.

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