Lowering interest rate won't be enough to tame capital flow
Can lowering the policy rate fend off capital flows and upward pressure on the baht? Assuming interest-rate-chasing capital, many proponents are putting more pressure on the policy rate in the face of liquidity injections by major central banks around the world.Under similar assumptions, when Asian currencies depreciated sharply from capital flight in 1997-98, one of the first policy prescriptions was to raise the interest rate to try to attract capital back. Sadly, not only did the prescription not work, it also buried local businesses under a mountain of debts and interest payments. Good thing that the prescription is no longer given nor followed during this round of crises.
This assumption of "interest-rate-chasing capital" is based on "interest rate parity". Put plainly, when the interest rate in one economy is higher than another, money will flow to the higher interest rate economy, causing currency appreciation and expected future depreciation - what goes in must come out - that offsets the profit opportunity. This hypothesis is simple and yet powerful, explaining the reason why it is virtually in all undergraduate business, finance and economics textbooks.
But what the economics profession hardly informs its students is the failure of the theory under empirical testing. Interest rate parity ranks among the most heavily tested theories in economics, with regressions being run for pretty much almost any economy in the world with decent data. This shows how much the theory makes sense and how much we wanted it to be true. In fact, there are still doctoral students today who search very hard to find "new evidence" of interest rate parity.
But this Holy Grail of economics never turns up. Despite the heavy digging and testing, the evidence came up very thin, except for a very few short and specific times and certain economies. And when evidence shows up, it typically is not what we think it would be.
Interest rate parity only works for a short period of time, at best no more than three months, with the exchange rate fixed by financial contract, for example, in carry trades. Only within these three months can the interest rate be somewhat effective in influencing carry trade flows. However, if exchange rates are not pinned down by a forward or futures contract, then there is no evidence of interest rate parity. Moreover, this only works for developed economies. Evidence for developing and emerging economies like ours only scantly supports the theory, except for a three- to 10-year horizon.
The theory is also abused in other ways. For example, it also states that capital flows arbitrage profit opportunities until they are gone. Hence the direction of capital flows can only be predicted off equilibrium, before profit opportunities are arbitraged away or before exchange rates move to offset the returns. Once in equilibrium, any changes in interest rates may in fact cause exchange rates to overshoot, inducing unnecessary excess volatility in exchange rates.
The empirical failure of interest rate parity should be enough to convince anyone that one interest rate alone cannot achieve everything. For example, capital poured into the Thai bond market more in 2012 when the policy rate was lower than in 2011. Thus, there are a lot more factors that influence capital flows and exchange rate movements. There are also other non-interest bearing asset classes such as real estate, stocks and commodities that attract capital.
It takes more than an interest rate adjustment to fend off the massive liquidity that may head this way, and authorities are better off focusing their efforts sector-by-sector. Sector- and market-specific measures are much more effective in keeping capital flows in check and ensuring the stability of our economy. Pointing at the interest rate alone to fight capital flows and appreciation pressure on the baht, though theoretically correct, is not empirically sound.
Views expressed in this article are those of the authors and not of TMB Bank or its executives.
Benjarong Suwankiri, head of TMB Analytics, the economic analysis unit of TMB Bank, can be reached at email@example.com.