International Review of Economics and Finance 8 1999 213–222
Interest rate dynamics and speculative trading in a fixed exchange rate system
Abraham Abraham
Finance Economics Department, College of Industrial Management, King Fahd University of Petroleum and Minerals, PO Box 479, Dhahran 31261, Saudi Arabia
Received 7 August 1995; accepted 29 December 1997
Abstract
Recent evidence provided by Diebold, Gardeazabal, and Yilmaz 1994 for the post-1973 floating rate period points toward the predictive superiority of a martingale representation of
exchange rate evolution over that of an error correction model that assumes rates are cointe- grated. This is an appealing result from the perspective of efficient assimilation of randomly
arriving information. As a direct extension of informational efficiency in a fixed exchange rate regime, I show that information is processed and assimilated through the medium of interest
rates. Specifically, I demonstrate that interest rates cannot be represented as a cointegrated system, even when the central bank is willing to establish its determination and resolve to
maintain the fixed rate rule over a sustained and prolonged period of time. Evidence provided in this paper is for the interest rate behavior of the Saudi Arabian Riyal with respect to the
eurodollar interest rate, the interest rate on the intervention currency.
1999 Elsevier Science
Inc. All rights reserved.
Keywords: Fixed exchange rate; Interest rate; Cointegration; Speculation
1. Introduction
With the introduction of flexible exchange rates in 1973, a considerable amount of work has been done on examining the dynamic behavior of real and nominal interest
rates, and of spot and forward exchange rates, by Meese and Singleton 1982, Meese and Rogoff 1983, Hakkio 1981, and Hansen and Hodrick 1980, among others.
Preliminary evidence from Baillie and Bollerslev 1989 suggested that nominal exchange rates are cointegrated at least for the major currencies in the developed economies,
implying a linear equilibrium relationship across currencies. More recently however,
Corresponding author. Tel.: 966-3-860-2228; fax: 966-3-860-2585. E-mail address
: abrakfupm.edu.sa A. Abraham 1059-056099 – see front matter
1999 Elsevier Science Inc. All rights reserved.
PII: S1059-05609900016-7
214 A. Abraham International Review of Economics and Finance 8 1999 213–222
Diebold, Gardeazabal, and Yilmaz 1994, using the same data set, but employing more sophisticated statistical methods, reject the initial findings of Baillie and Bollerslev,
showing that exchange rates cannot be viewed as a cointegrated system. This raises an interesting question: How is the intrinsic unpredictability in nominal exchange rates
manifested under a fixed exchange rate policy? Clearly it must be the case that there is a translation from nominal exchange rates held fixed spilling over into interest rates,
the non-cointegrability in exchange rates if allowed to float reflecting itself in the structure of interest rates across the currencies.
Fixed exchange rates are the exception rather than the rule, and yet a number of economies actively pursue a policy of fixed exchange rates, generally pegged to the
US dollar. This has been particularly true of the foreign exchange “rich” OPEC countries, such as Saudi Arabia and the Gulf Cooperative Council GCC states in
the Middle East.
1
Loss of monetary control is a natural consequence of such a policy Kimbrough, 1984, where domestic credit availability has to be matched with demand.
Discretionary control is lost, as external deficits have to be matched by the sale of foreign exchange from government reserves, reducing high powered money stock.
More importantly, arbitrage activity in a fixed exchange environment places more strain on the management of foreign reserves causing disruptions to system liquidity.
As pointed out by Kimbrough 1984 monetary authorities have to offer to exchange money for bonds at a price equal to the domestic currency price of foreign bonds
which is consistent with the spot rate rule. This is no more than an operational statement asserting that interest rates for equivalent investments must be equal across
the two currencies. This places readily testable implications on the behavior of interest rates in such an environment.
Scant attention has been paid in the literature on the behavior of interest rates in such a pegged environment, especially with respect to the ability of the central bank
to maintain its credibility and avoid speculative attacks on government stocks. In this paper, I look at the specific case of Saudi Arabia, in particular from the period of
January 1988 to March 1994 the period for which published data on short term interest rates are available. A credible policy of pegged exchange rates would imply
a stable equilibrium relationship between the domestic interest rates domestic cost of credit and the interest rate in the intervention currency the dollar interest rate.
I examine whether short term rates in the two currencies can be modeled as a cointe- grated system—a direct test of the effectiveness of the stated exchange rate policy—
while speculative trading induced through expectations of currency realignment should destroy the equilibrium in interest rates across the two currencies. As long as market
participants in each period assign a non zero probability which could be time varying to the realignment event, it should preclude a linear stationary representation of
the system of interest rates. Probability evaluations will be strongly influenced by macroeconomic signals, in particular the balance of payments and the level of foreign
exchange reserves required to defend the policy regime. A number of studies have examined exchange rate expectation processes in a flexible exchange rate system—
notably, Dornbusch 1976, Frenkel and Froot 1987 and Genberg 1984—identifying various macroeconomic variables that influence expectations.
A. Abraham International Review of Economics and Finance 8 1999 213–222 215
The paper is organized as follows. Section 2 provides an overview of the exchange rate policy in Saudi Arabia and discusses the basis of the proposed tests. Section 3
presents the principal findings of the study; section 4 concludes.
2. Methodology
