Do High Interest Rates Defend Currencies During Speculative Attacks?

That is the question posed by a paper (pdf) by Aart Kraay of the World Bank, written in 2001 and focusing mainly on fixed exchange rate scenarios.  It seems the high rates do not protect currency values, here is the abstract:

Do high interest rates defend currencies during speculative attacks? Or do they have the perverse effect of increasing the probability of a devaluation of the currency under attack? Drawing on evidence from a large sample of speculative attacks in developed and developing economies, this paper argues that the answer to both questions is ”no”. In particular, this paper documents a striking lack of any systematic association whatsoever between interest rates and the outcome of speculative attacks. The lack of clear empirical evidence on the effects of high interest rates during speculative attacks mirrors the theoretical ambiguities on this issue.

This study (jstor) from the JPE, by Lahiri and Vegh, shows mixed results and also explains why the higher interest rates may be counterproductive.  They increase public debt service and may predict higher future inflation, thereby worsening some of the constraints and possibly hastening a further speculative attack.

Here is an Allan Drazen survey on raising interest rates to defend a currency (pdf), much of which focuses on the signaling effect.  He argues the non-signaling effects are generally weak and when it comes to the signaling effects it can cut either way.  Needing a large rate hike to defend a currency is in some ways a negative signal as well.  The empirics are discussed starting on p.51 and one result seems to be short-term benefits and medium-term deterioration, following a big interest rate hike to protect a currency.  Again, you will note this estimation is drawn from a lot of fixed rate countries and it may apply to floating rate scenarios only with qualifications.

You will find other relevant readings here.

The big news, of course, is that the Turkish central bank yesterday announced a 425bp rate hike, to stem a currency crisis.  There is FT Alphaville on the move here, more readings here.  The markets seem to like this move, at least at first, but based on what we know from the literature, we should not be too quick to think this will succeed.


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