Interest rates in open economies : real interest rate parity, exchange rates, and country risk in industrial and developing countries

The paper tests for the relative importance of international capital market integration in determining interest rates in a broad sample of both industrial and developing countries. The recent turbulence in industrial country financial markets has underscored these concerns. One view holds that it is possible for countries to conduct an independent domestic interest rate policy. The other suggests that there is very little room for managing interest rates in open economies without destabilizing effects on exchange rates - given the massive volumes of capital market transactions that force interest rate parity across countries. Interest rate formation in developing countries has attracted much less attention. But it is an increasingly important issue as a growing number of them undertake financial liberalization. The central question for policy-makers is again the degree to which domestic interest rates are influenced by world interest rates. A separate concern is high domestic interest rates, relative to world interest rates, in some developing countries. A model of real interest rate parity is proposed as the main test for capital market integration - that is, that nominal interest rate differences across countries are largely explained by inflation differentials (rather than uncovered or covered nominal interest parity). The evidence suggests strongly that although domestic monetary policies play a significant role, real interest parity is a dominant factor, in both industrial and developing countries. However, expectations of exchange rate changes also significantly influence interest rates. A third key factor is the apparent presence of significantcountry risk, unexplained by macroeconomic imbalances, for some developing countries (for example, Chile, Indonesia, Mexico, and the Philippines) pushing real domestic interest rates higher than what would be otherwise predicted. The concluding section discusses the possible reasons for suchcountry-riskin the case of Indonesia.