Concurso “Vendiendo con visión de mercado”

Response to US interest rate: The primary objective of this work is to examine whether there is a systematic difference in the degree of monetary independence between countries operating fixed exchange rate regimes and those with more flexible rates. Splitting the results according to the exchange rate regime did not reveal a substantial difference between the two systems in terms of the responsiveness to US interest rates. Using the individual ECM equations, the average speed of adjustment is only slightly faster for fixed regimes (0.3) than for flexible regimes (0.22), while the LR impact of US interest rates on domestic interest rates is larger for flexible regimes (2.8) than for fixed regimes (1.5). In almost all the cases of both fixed and flexible regimes, the coefficient on the long- run impact of the US interest rate was strongly statistically significant. The short- run impact of the US interest rate was, in the majority of episodes, very small and statistically insignificant. The few exceptions were Argentina, Egypt, Malaysia, Morocco and South Africa, representing six exchange rate episodes where the coefficients on the short-run US interest rate were statistically significant. In those six cases, the average magnitude of the coefficient in the flexible regime episodes was smaller than that for the fixed regimes (0.75 and 1.35 respectively), however it is still relatively high. The largest short-run coefficient on the US interest rate was 2.3 during Argentina’s currency board.

This lack of systematic difference in responsiveness to world interest rates and the observed inability of flexible regimes to insulate the domestic economy from world interest rate shocks had been previously emphasised in the literature (Frankel, et al 2002; Borensztein, 2001)

Response to own inflation and output gap: As mentioned earlier, monetary independence is defined as the ability of a developing country to respond to its domestic variables and operate a meaningful monetary policy despite the strong influence of world interest rates. Therefore, in addition to considering the response of domestic interest rates to the US interest rate, the ability to react to domestic inflation and output gap is examined. An overview of the results shows that the magnitude of the average long-run coefficient on inflation is almost twice as large for flexible regimes (0.40) as for fixed regimes (0.23), which may be interpreted as a higher degree of monetary independence under flexible exchange rate regimes;

however in most cases, the coefficient is not statistically significant; the inflation coefficient is significant in about 33% of the cases divided equally between fixed and flexible exchange rate regimes. Where quarterly GDP data is available, the coefficient on the output gap differential between the domestic economy and the US economy (referred to hereafter as responsiveness to output gap) is much higher for flexible regimes (1.9) than for fixed regimes (0.60) and is statistically significant in 50% of the cases, all of them are episodes where the country was operating a

flexible regime.24

This overview of the results shows no systematic difference between fixed and flexible regimes in terms of the independence of monetary policy, however there are significant differences among individual cases/countries in that respect. For example, comparing Argentina and the Philippines, both in the fixed regime category, shows a strong response to the US interest rate in the long-run with statistically significant coefficients of 2.5 and 3.6 respectively where the difference is not statistically significant, yet a considerable difference exists in both the speed of adjustment and the response to domestic variables. Argentina’s speed of adjustment is 0.5 while that of the Philippines is only 0.10, where the difference is

strongly significant. At the same time, the coefficient on inflation in Argentina is a

statistically significant (0.40), while that for the Philippines is a statistically insignificant (0.48). In the present context, this implies that Argentina, despite its currency board uses monetary policy to some extent to achieve domestic objectives, while the Philippines does not. Interest rates in both countries do not respond to the output gap variable as shown in the insignificance of the coefficients. A similar comparison from the flexible regimes category is between Chile and Sri Lanka over the period of time from 1998 to 2003/04. Chile has a speed of adjustment of 0.39 and shows a strong long-run response to US interest rates (1.5) and a similarly strong response to domestic inflation (coefficient of 1.54). Sri Lanka has a very slow speed of adjustment (0.07) but a stronger response to the US interest rate in the long-run (2.7) and no significant impact of domestic inflation on the interest rate. Both the differences in the speed of adjustment and the long-run response to the US interest rate between the two countries are statistically significant.

24 _{Quarterly GDP data was only available for two countries operating a fixed rate regime, Argentina}

Two observations arise from the previous cases; first, the exchange rate regime is not the determining factor for monetary independence and another dimension of the monetary framework has to be considered. Second, operating a peg, even a hard peg like Argentina’s, does not necessarily eliminate completely – in practice – the ability to use monetary policy for domestic objectives.

Impact of CBI on LR coefficient and responsiveness to domestic variables: The next dimension of the monetary framework to be considered when explaining monetary independence is the degree of central bank independence as an indicator for monetary policy credibility and soundness. One explanation for the ability of a country to pursue domestic targets despite the strong influence of world interest rate is a track record of successful monetary management. To introduce CBI as another dimension of the monetary framework along with the exchange rate regime, the sample was split according to the degree of CBI into three groups of high, medium and low CBI. About a third of the countries in the sample are classified as having a high degree of CBI (6 out of 19 countries and 15 out of 34 episodes in total). Throughout the results, there are several cases where countries with high CBI can be contrasted with those with medium or low CBI in terms of the response to domestic variables. For example, the results for Chile and Colombia with high CBI rating can be compared with those for Bolivia, Guatemala and Sri Lanka. Despite the strong and significant impact of the US interest rate on the interest rates in Chile and Colombia (coefficients of 1.5 and 2.3 respectively), both countries show a strong response to their own domestic variables. The coefficients on domestic inflation are 1.5 and 1.1 respectively and are statistically significant. The interest rate in Colombia is also responsive to the output gap with a statistically significant coefficient of 2.1. These results can be contrasted with the responsiveness of interest rates to domestic variables in countries with low CBI rating. Taking the cases of Bolivia, Guatemala and Sri Lanka, the results show that they all respond strongly to the US interest rate with statistically significant coefficients of 0.9, 0.7, and 2.5 respectively, while the response to domestic inflation is very weak at 0.01,

0.12, and 0.3 respectively and is statistically insignificant25_.

25 _{Over the period from 2000 to 2004, the responsiveness of the interest rate in Guatemala to}

The remaining cases/episodes indicate clearly that all countries with a high degree of CBI are able to respond to either or both domestic inflation and output gap where the coefficients are strongly significant. This is in contrast to the groups of medium and low CBI where in most cases domestic interest rates react only to US interest rates. In a few cases (4 out of 14 low-CBI episodes) domestic interest rates responded to domestic inflation. The lack of quarterly GDP data for countries classified in the low CBI category prevented testing the response to the output gap in this category. The details of the regression results for all episodes along with the CBI rating are provided in the appendix to this chapter.

It is also interesting to take a closer look at the results of individual countries over time, where several observations can be made. Taking the case of Mauritius in the flexible exchange rate category, it is noted that over the entire period from 1987 to 2004, the regression results show that monetary policy only responded to US interest rates; however, splitting this long period of time into two sub-periods shows that during the earlier period, 1987-1994, the domestic interest rate was responding only to the US interest rate, while in the later period, 1995-2004, it was also responding with a fairly large coefficient (0.74) to domestic inflation. An interesting point to note about this case is that the response to the US interest rate became stronger over time (the long-run coefficient increased from 0.94 to 1.4) despite the increased responsiveness of the domestic interest rate to inflation. This also lends support to the relevance of a more precise understanding of monetary independence in more recent periods of time and shows that the interesting question is not whether the US interest rate has an impact on domestic monetary policy but rather if it leaves room for the pursuit of domestic objectives as well. The case of Brazil provides another example. Over the entire period of 1995-2002, the results show no statistically significant response to any of the explanatory variables. This is probably due to the inclusion of the period of a currency crisis and significant fears of devaluation during 1997/98. When considering two sub-periods and excluding the crisis months, it is clear that over time the impact of US interest rates was reduced greatly and became statistically insignificant over the later period. Also the response of monetary policy to domestic inflation in 1995-97 was replaced by a strong response to the output gap in 1999-2002.

In comparing countries with different degrees of CBI, it is also notable that countries with a higher CBI rating seem to move over time towards a monetary policy that is more geared towards their domestic variables and less influenced by US interest rates relative to those with low CBI. This is shown again in the results for Brazil (high CBI) and Mauritius (medium CBI) as discussed earlier, also for Colombia and South Africa, both with high CBI ratings. On the other hand, countries with a low CBI classification tend to maintain their degree of responsiveness to US interest rates over time, as in the case of Guatemala, or even increase it, as in the case of Sri Lanka, whose responsiveness to US interest rates shows a significant increase in the period 1998-2004 after the Asian crisis compared to the earlier period preceding it.

Correlation with US business cycle: It has been assumed in this literature that the responsiveness of the domestic interest rate to US interest rates signals a loss of monetary independence since the monetary authority is unable to set interest rates in response to its own inflation and output gap. The impact of the US interest rate was found to be equally strong whether a fixed or flexible exchange rate regime was in place. This observation undermines the major advantage of a flexible exchange rate regime in allowing a country to pursue domestic targets. In practice, however, the value of the monetary independence afforded by flexible exchange rate regimes depends on the extent to which business cycles are synchronised in the domestic and world economies, in this case the US economy. If there is a high degree of co-movement between the two business cycles, there is little to be gained by attempting to pursue a domestic monetary policy that is different from that pursued in the US, in which case responding to the US interest rate does not necessarily imply the loss of the ability to pursue domestic objectives. At the same time, the degree of monetary dependence would be made even stronger if the business cycles were not synchronised and yet the domestic interest rate was responding strongly to US interest rates. In the present work, correlation coefficients between the standardised domestic and US output gaps were calculated for each exchange rate episode in the sample. The results showed significant variation in the coordination of business cycles between countries and over time with more coordination in later periods and generally a stronger coordination between the US and Latin American countries in the sample.

The results show that the synchronisation of business cycles does not preclude the adoption of a flexible exchange rate regime; the countries whose business cycles show the strongest correlation with the US (Mexico and South Africa) operate flexible exchange rate regimes as classified by Reinhart and Rogoff (2002) and are considered to be ‘freely floating’ according to the official classification. In light of this observation, it is not very surprising to see an apparently strong influence of US interest rates on domestic interest rates despite the flexibility of the exchange rate regime. In those cases, the impact of US monetary policy on domestic interest rates does not in practice imply the loss of the ability to use monetary policy to achieve domestic objectives. Taking the case of Mexico with a high CBI rating, the results show that over the entire sample period 1990-2004, the correlation coefficient between output gaps is 0.38 and the regression results show that only the long-run coefficient on the US interest rate is statistically significant at the 10% level. However, this overall result masks significant differences over time and again is likely to be strongly influenced by the currency crisis in 1994. Eliminating the crisis period shows that over the episode from 1990-1994, the correlation coefficient between US and Mexican output gaps was -0.28 and the coefficient on the US interest rate was 0.36 and statistically insignificant. The only explanatory variable with statistical significance over that period was the output gap differential variable with a coefficient of 4.65. The post crisis episode from 1996-2004 shows high correlation between business cycles with a correlation coefficient of 0.68, and at the same time the response of Mexican monetary policy to US interest rates was strongly significant with a coefficient of 1.93. The response of monetary policy to the output gap variable increased slightly.

The reverse example is that of South Africa, where over time the dependency on US interest rates decreased as the coordination of business cycles declined. Over the period 1990-1995, in which South Africa’s exchange rate was classified as a managed float, the long-run coefficient on the US interest rate was 1.6, and it was the only variable with statistical significance. At the same time, the correlation coefficient between the output gaps was high at 0.69. During the later episode in this sample from 1999-2004, in which a floating exchange rate regime was in place, the correlation coefficient declined to 0.3 and the response to US interest rates also declined to 0.69 but remained statistically significant. However, monetary policy

also became responsive to domestic inflation and the coefficient on the inflation differential became statistically significant at 0.35. This result is also consistent with the adoption of an inflation-targeting monetary framework in South Africa in February 2000. It is also worth noting that the reduced influence of US interest rates coincided with a change in the exchange rate regime towards a freely floating regime compared to the previously managed float. Perhaps a closer look at South Africa as a detailed case study would shed some light on whether this reduced dependency on US interest rates is due to a change in monetary management and the central bank’s reaction function or simply a result of moving to a more flexible exchange rate regime as conventional theory predicts.

In the cases of Mexico and South Africa, considering the coordination of output gaps with the US provides complementary insights into the degree of monetary independence for these countries. It is possible to conclude that in the two cases the degree of monetary independence is actually higher than previously thought in similar research (Frankel et al, 2002). The influence of US interest rates does not undermine the achievement of domestic objectives. In addition, it is possible to argue that the central banks in those countries are able, at least to a certain extent, to lower their dependency on US monetary policy in line with the change in domestic conditions.

On the other hand, many countries in the sample show only weak co-movement with the US business cycle (even negative correlation in many cases) and yet exhibit strong responsiveness to US interest rates despite their flexible exchange rate regimes. While this result confirms the assertions made in the literature about the lack of monetary independence, it still should be viewed in relation to the ability of the country to respond to its domestic variables at the same time. In other words, despite the strong influence of US interest rates on domestic ones, is it still possible for a country to pursue domestic targets? From the results of this chapter, the answer is yes. All countries with an independent central bank that exhibit a negative correlation with the US business cycle are still able to respond to domestic inflation and the output gap. This is clear in the examples of Brazil, Chile, Colombia and Malaysia. In those cases, the negative correlation coefficient between US and domestic output gaps, although it may strengthen the argument for monetary dependence, coincides with the ability to respond to their domestic conditions as

shown by the reaction of interest rates to the inflation and output gap differentials. Countries with an independent CBI although influenced by US interest rates are still able to achieve some domestic objectives as shown in the strong and significant response to domestic inflation and output gap.