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The effect of foreign debt on currency values
J ECO BUSN
331
1993; 45:331-340
The Effect of Foreign Debt on Currency Values Richard A. Ajayi and Jongmoo Jay Choi
Despite the publicity surrounding the external debts of the less developed countries (LDCs), the effects of those debts on the exchange rates has not received much attention in the literature. This paper proposes a structural model that is a synthesis of an asset and a monetary model of exchange rates along the line of Frankel (1983), and modified to include external debt. Estimating this model for a sample of 18 LDCs shows that debt, in addition to the usual variables such as money supply and interest rates, has a largely significant and negative impact on the external values of most of the countries' currencies.
I. I n t r o d u c t i o n
The external debt of less developed countries (LDCs) has now become an international problem of crisis proportions. By the end of 1987, the total external debt of LDCs exceeded 1 trillion U.S. dollars. The accompanying debt-servicing obligations pose serious challenges not only for the borrower countries concerned because of the hardship imposed by necessary economic adjustment, but for the lenders, who face uncertain repayment. The LDC debt has thus become a source of potential instability that threatens the effective functioning of the international financial system. Among the policy alternatives available to an LDC government to alleviate debt-servicing burdens is the exchange rate policy. International lending institutions such as the International Monetary Fund also require exchange rate changes as a part of structural adjustments necessary for continued credits. However, although the relationship between the exchange rate and other macroeconomic variables has been examined extensively in the literature, the relationship between debt and exchange rates has received only scant attention. Moreover, previous research largely focuses on determination of exchange rates in an industrialized
The Department of Finance & Business Economics, Wayne State University, Detroit, Michigan (RAA); the Department of Finance, School of Business and Management, Temple University, Philadelphia, Pennsylvania (JJC). Address reprint requests to Jongmoo Jay Choi, Department of Finance, School of Business and Management, Temple University, Philadelphia, Pennsylvania 19122, or Richard A. Ajayi, Department of FBE, Wayne State University, Detroit MI 48202. Journal of Economiesand Business © 1993 Temple University
0148-6195/93/$06.00
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R . A . Ajayi and J o n g m o o Jay Choi
creditor-country setting, or estimates LDC currency exchange rates using models that are devoid of debt. This paper presents a model of exchange rates and debt, along the lines of Ajayi (1989), and estimates the model for selected LDCs. The model is a synthesis of the monetary and asset models of exchange rates with incorporation of debt. Estimation of this model for a sample of 18 developing countries shows that debt, in addition to the usual variables such as money supply and interest rates, has a largely significant and negative impact on the external values of most of the countries' currencies.
II. The Model To analyze the effect of external debt on currency values, we propose a structural model that is a synthesis of the monetary and asset models. A key difference between the two models is that the monetary model assumes perfect capital substitutability whereas the asset model (the portfolio balance variety) does not. The asset model is essential in modeling debt because the problem of debt would not arise in a world of perfect substitutability between domestic and foreign capital. The monetary model is useful because it anchors the long-run equilibrium exchange rate under the assumption of perfect capital substitutability and purchasing power parity. Following Frankel (1983), the two models are combined by an equation specifying the exchange rate expectation. We start with the standard monetary model, Frankel (1976) and Johnson (1973), and state the two money-market equilibrium conditions as m = P + Cly m* = P* + Cly*
C2r,
(1)
- C2r*,
(2)
where rn is the log of domestic money supply, P is the log of general level of prices, y is the log of real income, and r is the nominal interest rate. 1 The asterisk denote the foreign variables. The two coefficients, C1 and C2, are assumed to be identical for both domestic and foreign countries. To generate the model of exchange rates we rely on the purchasing power parity e = P - P*,
(3)
where e is the log of exchange rate, defined as the domestic currency value of a unit of foreign currency. Combining (1)-(3) gives the standard monetary model of exchange rates: = (m
- m*)
- C~(y -y*)
+ C2(r - r*).
(4)
Equation (4) depicts a long-run equilibrium exchange rate, ~, because it is based on an assumption that commodity prices are completely flexible. In the short run, however, prices may be sticky for various institutional reasons. Dornbusch (1976,
1 The interest rate can be defined as either nominal or real in the monetary model. We use the nominal interest rate here because the real interest rates are negative in several LDCs we studied because of government controls and imperfect indexation of nominal interest rates in the presence of high inflation rates.
Effect of Foreign Debt on Currency Values
333
1980) argues that an overshooting in exchange rates would result from this price stickiness and differential speed of price adjustment in the goods versus money markets. An unexpected easy domestic monetary policy, for instance, causes a long-run depreciation of domestic currency via inflation, but with sticky prices the resulting decrease in domestic interest rates causes a net capital outflow, thus contributing to further depreciation of domestic currency in the short run. The dynamic path of adjustment toward a long-run equilibrium requires an assumption on expectation. An implicit assumption on the monetary model is the perfect substitutability of assets, so that the money market equilibrium is sufficient to determine that exchange r a t e r In contrast, the asset model of exchange rates recognizes that domestic and foreign assets are imperfect substitutes and changes in the expected yields and risks associated with different securities lead to portfolio diversification, wealth redistribution, and, hence, exchange rate changes. The imperfect substitutability is an important characteristic of LDCs that are under domestic and foreign financing constraints. With perfect asset substitutability, external debt problems would not be an issue, because there would be no distinction between internal or external borrowing. The asset model, Branson and Henderson (1985) and Kouri (1976), can be expressed as B/eF = h(r - r*,~, z).
(5)
where B and F are the supplies of domestic and foreign bonds (denominated in domestic and foreign currency units, respectively) in the market, ~ is the expected rate of change in the level of exchange rates, and z is a variancecovariance parameter. Equation (5) can be rewritten as e = k + C3(r - r * ) + C4~ + C s ( b - f ) ,
(6)
where k, C3, C 4 and C 5 are arbitrary constants, and b = log B and f = log F. Because ~ = 0 at the long-run steady-state equilibrium, e is fully determined within the asset model. In the short run, however, the level of exchange rates depends on ~. Following Dornbusch (1976), we assume a partial adjustment process for exchange rate expectation: the exchange rate depreciates in proportion to the discrepancy betweent the long-run equilibrium exchange rate ~, and the current actual rate e. Given the importance of the oil prices for the economy of LDCs under study, we assume that the partial adjustment process is subject to an extraneous random oil-price shock. Thus, the expected change in exchange rate is
2 Perfect substitutability is similar but not identical to perfect capital mobility, another assumption often made in international finance. Perfect capital mobility implies the absence of transaction costs and other barriers to international capital flows.With perfect capital mobility, a deficit (or a surplus) in the current account is always financed by capital inflow (outflow). Perfect substitutability between domestic and foreign assets, on the other hand, assumes that investors are indifferent to the composition of their investment portfolios.
R.A. Ajayi and Jongmoo Jay Choi
334 specified as
(7)
= C.6(~ - e ) + g L ,
where C6 is the partial adjustment coefficient, L is the oil-price shock, and g is an arbitrary constant. To obtain the reduced form equation, we rewrite equation (7) as
(8)
e = ~ - (1/C6)(~ - g L ) . Then substituting equation (4) into (8) gives e = (m
- m*)
- Cl(y
-y*)
+ C2(r - r*) -
(1/C6)(~ - g L ) .
(9)
Solving for ~ in (6) and substituting the result into (9), the synthesized model is e = a o + al(m
- m*)
+ a2(y -y*)
+ a3(r - r*) + a4D + asL ,
(10)
where a o = k/(C4C 6 +
1),
a 1 = C4C6//(C4C6
a 3 = (C2C4C 6 + C3)//(C4C6
a 5 = C4g/(C4C 6 +
-t- 1 ) ,
'}-
1),
a 4 ~- C 5 / / ( 6 4 C 6
a 2 = C L C 4 C 6 / / ( C 4 C 6 qd-
1),
1),
1),
and D = b - f. Now consider the expected behavior of the parameters of equation (10). According to the monetary model, (m - m * ) and ( r - r*) should have positive coefficients, whereas ( y - y * ) should have a negative coefficient. Through money market adjustment, the foreign exchange value of the currency of the country with relatively easy monetary policy should decrease (or e should increase). Similarly, an increase in domestic interest rates should reduce domestic demand for money, causing a decrease in the value of domestic currency. An increase in domestic real income should raise the demand for money and induce domestic currency appreciation. According to the asset model, ( r - r*) should have a negative coefficient, because capital inflows, caused by high domestic interest rates relative to foreign interest rates, induce an appreciation of the domestic currency vis-?t-vis foreign currency. This is in conflict with the expected sign from the monetary model. The sign of the coefficient of (r - r*), therefore, depends on the relative importance of money versus asset markets in a given economy. In an inflationary environment, the rate of interest is likely to be dominated by inflationary expectations rather than by liquidity effects associated with changes in the ratio of money to bonds. Therefore, a high domestic interest rate is expected to affect the domestic currency negatively. In an economy with stable monetary policy and low inflation expectations, a high domestic interest rate is likely to induce capital inflows, with a positive impact on the domestic currency.
Effect of Foreign Debt on Currency Values
335
The effect of D operates through the asset market and differs for static and dynamic analysis. In a static context, foreign debt implies captial inflows and (ceterius paribus) leads to a strong domestic currency through asset equilibrium in the capital account. 3 A dynamic version of the asset model [e.g., Dornbusch (1976) and Kouri (1976)], however, incorporates the current account imbalances and their impact on a country's holding of net foreign assets. In a dynamic context, a deficit in the current account causes an increase in the country's external debt or a reduction in net foreign assets held by domestic residents, and this has a negative effect on the external value of the domestic currency. The net effect of D on e is, therefore, ambiguous due to the conflict between the static asset equilibrium in the capital account and the dynamic effect of the current account imbalances on net asset supply. The effect of the oil price shock depends on whether a country is net exporter or importer of oil. In the short-run when the demand for oil is price-inelastic, and assuming no constraint on production capacity, an increase in the world oil prices should permit current account surpluses or international reserve accumulation for oil exporting nations and consequently the appreciation of their currencies. Oil importing nations should experience the opposite e f f e c t . 4
I l L Estimation Result The synthesized model 5 is estimated with quarterly data from the fourth quarter of 1975 to the fourth quarter of 1987 for 18 developing or moderate-income countries. The data cover a period of recent exchange rate flexibility after the 1973 oil price shock. Country selection was guided by data availability on flexible currencies in LCDs during the period and reflects our desire to present the analysis across samples from oil-exporting, oil-importing, highly indebted, moderate-income, and the newly industrialized countries. Data definitions are as follows: e is the log of domestic currency units per unit of the U.S. dollar, m is the log of money supply (M1), y is the log of industrial production index, r is the nominal interest rate measured by the three-month treasury bill rate, D is the log of cumulative domestic current account deficits during the period, and L is the oil price shock measured by the price of crude petroleum in U.S. dollars in the world market. The asterisks denote corresponding U.S. variables. Table 1 presents the estimated results. The model was estimated by ordinary least squares (OLS) and the Cochrane-Orcutt (CORC) techniques to reduce autocorrelation. The OLS results exhibit the presence of serial correlation in all but 2 of the 18 countries, whereas, the CORC techniques display lower R-squares in general.
3 This is at odds with the traditional flow view based on the balance of payments: the current account deficits, which presage the external debt, have a negative impact on the domestic currency. 4 Alternatively, the oil price shock may be interpreted as a proxy for input price uncertainty for oil-importing nations. This interpretation, however, affects the exchange rate in the same direction as the one discussed in the text. 5 A parallel exposition is offered by Sachs (1986).
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R . A . Ajayi a n d J o n g m o o Jay Choi
Table 1. E s t i m a t i o n Results e = a o + a l ( m - m * ) + a2(y - y * )
Country Brazil
Method OLS CORC
Greece
OLS CORC
India
OLS CORC
Indonesia
OLS CORC
Israel
OLS CORC
Korea
OLS CORC
Malaysia
OLS CORC
Mexico
OLS CORC
Nigeria
OLS CORC
Peru
OLS CORC
Philippines OLS CORC Portugal
OLS CORC
a0
a1
-4.7597 (-2.455) -21.5606 (-3.885) 2.057 (0.970) -6.1071 (-4.463) -3.1680 (-9.984) -3.2167 (-6.390) 6.2327 (39.280) 6.1862 (18.121) -2.7342 (-5.101) - 2.2511 (-4.068) 6.0163 (39.28) 7.2600 (2.372) 1.6132 (10.071) 2.9677 (0.422) 1.1406 (0.873) 2.2417 (1.266) -0.5518 ( - 1.561) 2.4912 (5.518) -7.3817 (-2.953) 3.7559 (0.488) - 0.5555 (-0.949) 10.9399 (2.985) 4.1411 (1.308) 3.8470 (1.247)
0.8411 (23.234) 0.7242 (11.306) 0.4311 (1.696) 0.1456 (2.268) 0.1448 (5.400) 0.0641 (1.542) -0.6624 (12.561) -0.6090 (-8.983) 1.1296 (59.800) 1.1309 (39.957) -0.3023 (-7.661) -0.1445 (-3.350) -0.2248 (-3.609) 2.9677 (-4.609) 0.7532 (6.541) 0.8757 (5.910) 0.2161 (0.9940) 0.0148 (0.089) 0.5026 (5.602) 0.1809 (11.306) - 0.3317 (-1.864) 0.1462 (1.462) 1.6205 (2.379) 1.6167 (2.473)
az
+ a3(r - r * ) + a n D + a s L
a3
a4
-0.1215 0.0075 0.7737 (-0.401) (11.077) (3.654) -0.2345 0.0033 2.3345 (-1.636) (3.609) (4.456) -0.0550 0.0504 0.3175 (-0.739) (4.032) (1.586) 0.0049 -0.0044 1.1138 (0.305) (-0.869) (7.863) -0.1659 -0.0006 0.5737 (-1.964) (-0.213) (16.226) -0.0529 -0.0066 0.5781 (-0.819) (-2.248) (11.052) 0.1533 -0.0164 -0.0311 (4.007) (30.732)(-2.550) 0.0921 • -0.0149 0.0077 (1.589) ( - 17.356) (-0.0012) 0.1616 0.0009 -0.0194 (0.269) (7.883) (-0.269) 0.4781 0.0008 - 0.0678 (0.7740) (4.826) (-1.095) 0.0194 -0.0063 0.0327 (1.066) (-10.643) (2.197) -0.0720 -0.0016 0.0030 (-2.036) (-0.188) (0.333) 0.2207 0.0136 0.0043 (6.400) (7.285) (0.772) -0.2858 -0.0185 0.0005 (-0.317) (0.167) (-0.428) -3.5350 0.0182 0.2148 (-6.087) (5.281) (1.599) -2.4777 0.0150 0.1765 (-3.569) (3.328) (0.935) -0.5743 0.0269 0.0489 (-3.249) (2.237) (1.970) -0.4211 0.0009 -0.0030 (-2.429) (0.074) (-0.212) -0.2189 0.0281 1.3946 (-0.167) (3.552) (4.679) 0.1228 0.0076 0.6169 (0.647) (1.551) (-0.204) - 0.8744 0.0230 0.5419 (-4.908) (3.949) (10.379) -0.1207 0.0096 -0.5295 (-0.871) (1.969) (-1.929) 0.2990 0.0172 0.1614 (0.303) (0.623) (0.446) 0.2089 0.0159 0.1984 (0.218) (0.599) (0.564)
a5 -0.1776 (1.069) -0.1722 (-1.302) -0.2465 (-2.938) -0.0191 (-0.361) 0.0042 (0.191) -0.0265 (-1.074) 0.0786 (2.227) 0.0506 (0.168) 0.5026 (5.852) 0.4954 3.9590 0.0798 (2.881) 0.0703 (2.342) -0.1942 (-1.172) -0.0022 (0.390) -0.0297 (-0.157) -0.1409 (-0.723) -0.2423 ( - 1.708) -0.4509 (-2.767) 0.1615 (1.528) -0.2997 (0.815) - 0.3396 (-4.914) 0.0452 (-0.678) -0.4943 (-1.742) -0.5005 (-1.836)
R2
SE
DW
0.99 0.193 0.64 0.90 0.113 1.56 0.92 0.163 0.49 0.68 0.049 2.06 0.97 0.029 0.98 0.80 0.023 1.92 0.98 0.062 0.79 0.99 0.098 1.93 0.99 0.173 1.25 0.99 0.160 2.07 0.97 0.039 0.89 0.97 0.029 1.60 0.76 0.032 1.10 0.86 0.024 1.79 0.99 0.176 1.17 0.95 0.158 1.92 0.67 0.191 0.66 0.20 0.119 1.86 0.99 0.201 0.85 0.15 0.128 1.59 0.95 0.102 0.94 0.17 0.057 2.08 0.71 0.362 2.15 0.74 0.364 2.03
337
Effect of Foreign Debt on Currency Values Table 1. (continued) Country Method Singapore
OLS CORC
S. Africa
OLS CORC
Spain
OLS CORC
Srilanka
OLS CORC
Taiwan
OLS CORC
Turkey
OLS CORC
a0
a1
az
a3
a4
a5
1.2189 (14.365) 1.3094 (14.138) - 1.6280 (-5.853) 0.5598 (0.593) 0.3850 (1.144) 2.9141 (3.493) - 0.7049 (-1.938) 2.6609 (1.789) 3.8661 (58.258) 3.5860 (17.197) 0.3287 (0.156) -19.2802 (-4.369)
-0.2385 (-4.536) - 0.2037 (-4.247) 0.7909 (9.937) -0.0137 (-0.078) 0.0822 (0.499) 0.1329 (0.686) 0.9576 (5.066) -0.2379 (-1.391) -0.2301 (-9.904) - 0.0648 (-1.747) 0.8356 (5.059) 0.1116 (0.692)
-0.1087 (-2.520) - 0.0425 (-0.988) - 0.7699 (-3.026) -0.4435 (-1.258) - 1.9296 (-8.807) -0.3644 (-1.431) - 0.1662 (-0.781) -0.0293 (-0.267) 0.1457 (2.364) 0.0312 (0.457) - 0.0441 (5.998) -0.0487 (-0.532)
0.0046 (1.364) - 0.0007 (-0.233) 0.0003 (0.052) 0.0081 (1.138) 0.0108 (2.069) 0.0007 (0.256) 0.0041 (0.335) -0.0097 (-0.967) -0.0075 (-3.254) - 0.0009 (-0.413) 0.0272 (5.988) 0.0125 (1.697)
0.0196 (1.873) - 0.0297 (-1.806) - 0.0202 (-0.800) -0.0261 (-1.532) 0.4310 (14.307) 0.1703 (2.945) 0.1479 (1.621) 0.1672 (0.953) -0.0012 (-0.209) 0.0042 (0.512) 0.2973 (1.272) 2.4024 (5.129)
-0.0095 (-0.543) 0.0350 (1.754) - 0.2466 (-2.607) 0.7647 (0.850) -0.0520 (-0.999) 0.2215 (0.371) - 0.0683 (-0.703) -0.0181 (-0.166) 0.1680 (11.458) 0.0130 (0.605) 0.1830 (1.787) 0.1113 (0.707)
R 2 SE DW 0.84 0.026 1.14 0.91 0.020 2.15 0.88 0.145 0.63 0.11 0.085 1.91 0.95 0.088 0.99 0.22 0.054 1.94 0.88 0.155 0.97 0.08 0.098 1.45 0.90 0.032 1.09 0.96 0.021 1.46 0.98 0.185 1.54 0.77 0.149 1.99
Data Sources: International Finanacial Statistics, IMF, World Debt Tables, World Bank, Statistical Abstract of Latin America, UCLA Latin American Publication, and Financial Statistics, Cenral Bank of China, Taipei. Note: Figures in Parentheses are t values; DW is the Durbin-Watson statistic; SE is the standard error of residuals.
Estimation results based on the CORC are generally consistent with model predictions. First, the coefficients of (m - m* ) are positive (on the value of foreign currency in terms of domestic currency) in 11 cases and negative in the remaining 7. In the cases where these coefficients are positive, they are also significant (at 95% on a two-tail test) in about half the cases, just like the negative ones, which are also significant in about half of the occurrences. Second, the coefficients of (y - y * ) are weakly consistent with the monetary view, because they are negative in 12 of the 18 cases. However, regardless of signs, most coefficients are statistically insignificant (15 out of 18). This result contrasts with most empirical evidence on major industrial currencies. The reason for this difference between currencies of LDCs and industrialized nations is not clear. Our conjecture is that it is a consequence of largely underdeveloped financial markets in the LDCs, so that the effect of real income is not fully captured in a monetary model. Third, the result on (r - r*) is mixed. The coefficients are positive and significant in four countries, and negative and significant in two countries. The rest have insignificant coefficients. However, the fact that the coefficients are positive in 11 out of the 18 cases is fairly consistent with the monetary model or the dynamic version of the asset model, but inconsistent with the static asset equilibrium. The static model may fail because a favorable domestic interest rate is not sufficient for
338
R.A. Ajayi and Jongrnoo Jay Choi significant capital inflows to these countries given the political risks and restrictions on currency conversion. Fourth, the debt factor has a positive impact on e (or a negative impact on the value of domestic currency) in 12 out of 18 cases. Moreover, the coefficients are positive for all five countries that are significant at the 95% level (Brazil, Greece, India, Spain, and Turkey). The explanation of this result is that, for most developing economies, the growth of external debt can be traced to prolonged current account deficits a n d / o r capital flights, with an inevitable domestic currency depreciation. These results are contrary to the static asset view, but consistent with the dynamic asset model that incorporates the current account flows. Countries with negative coefficients are exceptions, and include Singapore, Israel, and South Africa. These economies are more advanced than the others. Given their developed financial markets, their debts can be explained m the context of a static asset model, where the external debt implies excess foreign demand for domestic assets, and such a pressure enhances the external value of the domestic currency. Fifth, the oil price coefficients are not significant in 15 of the 18 cases. It is, however, noteworthy that in the remaining three cases, Nigeria, Korea, and Israel, where the coefficients are significant, the sign is negative in the case of Nigeria, an oil exporting nation, and positive in the cases of Israel and Korea which are oil importing nations. In Table 2 we present an analysis of the responsiveness of the exchange rates to the debt and oil terms across economic and geographical blocks of the sample LDCs. It is interesting to note that the currencies of the newly industrialized Asian nations of Korea, Singapore, and Taiwan (block C), on the average, show the least responsiveness to the debt and oil factors. The oil exporting countries in block A are second on this score with their currencies showing a surprisingly mild responsiveness to both debt and oil factors. On the other hand, currencies of the three Latin American countries in the sample (block D) are the most influenced (negatively) by the debt factor. These are in turn followed, respectively, by countries in block E (moderate-income Mediterranean countries) and those in block B (highly indebted nations). The oil price is generally weak and not significant across the blocks, with this effect being slightly more pronounced in the Latin American block. Debt and oil prices may be correlated enough to make their individual effects insignificant. To explore this further, we estimated the synthesized model [equation (10)] excluding either of these two terms. The model performs markedly better without the oil term than without the debt term (results not reported). Overall, the external debt and the relative money supply terms contribute the most whereas the real income and the oil price terms contribute the least in determination of exchange rates in the sample LDCs under study during the recent flexible exchange rate period.
IV. Summary and Conclusions The connection between external debt and exchange rates has not received much attention in the literature. The literature on LDC debt is primarily concerned with the debt-servicing capacity of the borrowing countries and the implication of debts from the standpoint of lenders and the international financial system. The models
Effect of Foreign Debt on Currency Values
339
Table 2. A Comparative Analysis of Debt and Oil Coefficients (from the Cochrane-Orcutt Method) Debt Block A : O i l E x p o r t i n g Countries a Indonesia Mexico
Nigeria Average
0.0077 0.1765 - 0.0030
Oil
0.0506 - 0.1409 - 0.4509 b
0.0604
- 0.1804
2.3345 b
- 0.1772
Block B : H i g h l y Indebted Countries Brazil Mexico Nigeria
0.1765 - 0.0030
Philippines Average
- 0.5295 ~ 0.4946
Block C: Newly Industrialized Asian Countries Korea 0.0030 Singapore - 0.029"?" Taiwan
Average
- 0.1409 - 0.45090 0.0452 - 0.1809
0.0703 b 0.035(/:
0.0042
0.0130
- 0.0075
0.0394
Block D: Latin American Countries Brazil
2.3345 b
- 0.1722
Mexico
0.1765
- 0.1409
Peru
0.6169
- 0.2997
1.0426
- 0.2043
Average
Block E: Moderate-Income and Mediterranean Countries Greece 1.1138 b Israel - 0.0678 Portugal 0.1984 Turkey 2.4024 b Spain
Average
- 0.0191 0.4954 h - 0.5005¢ 0.1113
0.1703 b
0.2215
0.7634
0.6172
a T h i s c o n t r a s t s with the average coefficients of 0.4622 and 0.0476 for debt and oil, respectively, in the case of 15 non-oil exporting countries in the sample. h Significant at 95% confidence interval (two-tailed test). c Significant at 90% confidence interval (two-tailed test).
of exchange rates include money, interest rates, inflation, and the balance of payments variables, but not debt. This paper examines the effect of external debt on the values of LDC currencies using a model of exchange rates that synthesizes the monetary approach and the asset view and incorporates a debt factor. The model is estimated for 18 countries and the results indicate that external debts have significant negative impact on the currency values of most of these countries. The results also show that relative money supply and interest rates are important, whereas the effects of income and oil prices are generally weak and insignificant. The result has important implications for debt and exchange rate management in the LDCs. It suggests that a coordinated management of debts and exchange rates holds greater promise of success than an independent management of these
R.A. Ajayi and Jongmoo Jay Choi
340
variables, It also underscores the need for authorities in the LDCs to pursue debt reduction measures and thereby arrest a potentially vicious cycle of debt accumulation followed by exchange rate depreciation.
References Ajayi, R. A. May 1989. Essays on oil, external debts, and optimal exchange rates in the developing economies. Unpublished Ph.D dissertation (Temple University Phila. PA). Black, S. W. December 1976. Exchange policies for less developed countries in a world of floating rates. In Essays in lntemationalFinance 119. Princeton, N J: Princeton University Press. Branson, W. H. and Henderson, D. W. 1985. The specification and influence of asset markets. In Handbook of International Economics, Vol. 2 (R. Jones and P. Kenen, eds.). Amsterdam: North-Holland, pp. 749-805. Dornbusch, R. December 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84:1161-1176. Dornbusch, R. 1980. Exchange rate economics: Where do we stand. Broolangs Papers on Economics Activity 1:143-194. Dornbusch, R., and Fischer, S. December 1980. Exchange rates and current account. American Economic Review 70:960-970. Frankel, J. 1983. Monetary and portfolio-balance models of exchange rate determination. In Economic Interdependence and Flexible Exchange Rates (J. S. Bhandari and B. H. Putnam, eds.). Cambridge, MA: MIT Press. Frenkel, J. A. May 1976. A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence. Scandinavian Journal of Economics 78:200-224. Johnson, H. G. 1973. The monetary approach to the balance of payments. In International Trade and Money (M. Connoly and A. Swoboda, eds.). London: George Allen and Unwin. Kouri, P. J. K. May 1976. The exchange rate and the balance of payments in the short run and in the long run: A monetary approach. Scandinavian Journal of Economics 78:280-304. Sachs, J. 1986. Managing the LDC debt crisis. Brookings Papers on Economic Activity 2:397-440.
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1993; 45:331-340
The Effect of Foreign Debt on Currency Values Richard A. Ajayi and Jongmoo Jay Choi
Despite the publicity surrounding the external debts of the less developed countries (LDCs), the effects of those debts on the exchange rates has not received much attention in the literature. This paper proposes a structural model that is a synthesis of an asset and a monetary model of exchange rates along the line of Frankel (1983), and modified to include external debt. Estimating this model for a sample of 18 LDCs shows that debt, in addition to the usual variables such as money supply and interest rates, has a largely significant and negative impact on the external values of most of the countries' currencies.
I. I n t r o d u c t i o n
The external debt of less developed countries (LDCs) has now become an international problem of crisis proportions. By the end of 1987, the total external debt of LDCs exceeded 1 trillion U.S. dollars. The accompanying debt-servicing obligations pose serious challenges not only for the borrower countries concerned because of the hardship imposed by necessary economic adjustment, but for the lenders, who face uncertain repayment. The LDC debt has thus become a source of potential instability that threatens the effective functioning of the international financial system. Among the policy alternatives available to an LDC government to alleviate debt-servicing burdens is the exchange rate policy. International lending institutions such as the International Monetary Fund also require exchange rate changes as a part of structural adjustments necessary for continued credits. However, although the relationship between the exchange rate and other macroeconomic variables has been examined extensively in the literature, the relationship between debt and exchange rates has received only scant attention. Moreover, previous research largely focuses on determination of exchange rates in an industrialized
The Department of Finance & Business Economics, Wayne State University, Detroit, Michigan (RAA); the Department of Finance, School of Business and Management, Temple University, Philadelphia, Pennsylvania (JJC). Address reprint requests to Jongmoo Jay Choi, Department of Finance, School of Business and Management, Temple University, Philadelphia, Pennsylvania 19122, or Richard A. Ajayi, Department of FBE, Wayne State University, Detroit MI 48202. Journal of Economiesand Business © 1993 Temple University
0148-6195/93/$06.00
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R . A . Ajayi and J o n g m o o Jay Choi
creditor-country setting, or estimates LDC currency exchange rates using models that are devoid of debt. This paper presents a model of exchange rates and debt, along the lines of Ajayi (1989), and estimates the model for selected LDCs. The model is a synthesis of the monetary and asset models of exchange rates with incorporation of debt. Estimation of this model for a sample of 18 developing countries shows that debt, in addition to the usual variables such as money supply and interest rates, has a largely significant and negative impact on the external values of most of the countries' currencies.
II. The Model To analyze the effect of external debt on currency values, we propose a structural model that is a synthesis of the monetary and asset models. A key difference between the two models is that the monetary model assumes perfect capital substitutability whereas the asset model (the portfolio balance variety) does not. The asset model is essential in modeling debt because the problem of debt would not arise in a world of perfect substitutability between domestic and foreign capital. The monetary model is useful because it anchors the long-run equilibrium exchange rate under the assumption of perfect capital substitutability and purchasing power parity. Following Frankel (1983), the two models are combined by an equation specifying the exchange rate expectation. We start with the standard monetary model, Frankel (1976) and Johnson (1973), and state the two money-market equilibrium conditions as m = P + Cly m* = P* + Cly*
C2r,
(1)
- C2r*,
(2)
where rn is the log of domestic money supply, P is the log of general level of prices, y is the log of real income, and r is the nominal interest rate. 1 The asterisk denote the foreign variables. The two coefficients, C1 and C2, are assumed to be identical for both domestic and foreign countries. To generate the model of exchange rates we rely on the purchasing power parity e = P - P*,
(3)
where e is the log of exchange rate, defined as the domestic currency value of a unit of foreign currency. Combining (1)-(3) gives the standard monetary model of exchange rates: = (m
- m*)
- C~(y -y*)
+ C2(r - r*).
(4)
Equation (4) depicts a long-run equilibrium exchange rate, ~, because it is based on an assumption that commodity prices are completely flexible. In the short run, however, prices may be sticky for various institutional reasons. Dornbusch (1976,
1 The interest rate can be defined as either nominal or real in the monetary model. We use the nominal interest rate here because the real interest rates are negative in several LDCs we studied because of government controls and imperfect indexation of nominal interest rates in the presence of high inflation rates.
Effect of Foreign Debt on Currency Values
333
1980) argues that an overshooting in exchange rates would result from this price stickiness and differential speed of price adjustment in the goods versus money markets. An unexpected easy domestic monetary policy, for instance, causes a long-run depreciation of domestic currency via inflation, but with sticky prices the resulting decrease in domestic interest rates causes a net capital outflow, thus contributing to further depreciation of domestic currency in the short run. The dynamic path of adjustment toward a long-run equilibrium requires an assumption on expectation. An implicit assumption on the monetary model is the perfect substitutability of assets, so that the money market equilibrium is sufficient to determine that exchange r a t e r In contrast, the asset model of exchange rates recognizes that domestic and foreign assets are imperfect substitutes and changes in the expected yields and risks associated with different securities lead to portfolio diversification, wealth redistribution, and, hence, exchange rate changes. The imperfect substitutability is an important characteristic of LDCs that are under domestic and foreign financing constraints. With perfect asset substitutability, external debt problems would not be an issue, because there would be no distinction between internal or external borrowing. The asset model, Branson and Henderson (1985) and Kouri (1976), can be expressed as B/eF = h(r - r*,~, z).
(5)
where B and F are the supplies of domestic and foreign bonds (denominated in domestic and foreign currency units, respectively) in the market, ~ is the expected rate of change in the level of exchange rates, and z is a variancecovariance parameter. Equation (5) can be rewritten as e = k + C3(r - r * ) + C4~ + C s ( b - f ) ,
(6)
where k, C3, C 4 and C 5 are arbitrary constants, and b = log B and f = log F. Because ~ = 0 at the long-run steady-state equilibrium, e is fully determined within the asset model. In the short run, however, the level of exchange rates depends on ~. Following Dornbusch (1976), we assume a partial adjustment process for exchange rate expectation: the exchange rate depreciates in proportion to the discrepancy betweent the long-run equilibrium exchange rate ~, and the current actual rate e. Given the importance of the oil prices for the economy of LDCs under study, we assume that the partial adjustment process is subject to an extraneous random oil-price shock. Thus, the expected change in exchange rate is
2 Perfect substitutability is similar but not identical to perfect capital mobility, another assumption often made in international finance. Perfect capital mobility implies the absence of transaction costs and other barriers to international capital flows.With perfect capital mobility, a deficit (or a surplus) in the current account is always financed by capital inflow (outflow). Perfect substitutability between domestic and foreign assets, on the other hand, assumes that investors are indifferent to the composition of their investment portfolios.
R.A. Ajayi and Jongmoo Jay Choi
334 specified as
(7)
= C.6(~ - e ) + g L ,
where C6 is the partial adjustment coefficient, L is the oil-price shock, and g is an arbitrary constant. To obtain the reduced form equation, we rewrite equation (7) as
(8)
e = ~ - (1/C6)(~ - g L ) . Then substituting equation (4) into (8) gives e = (m
- m*)
- Cl(y
-y*)
+ C2(r - r*) -
(1/C6)(~ - g L ) .
(9)
Solving for ~ in (6) and substituting the result into (9), the synthesized model is e = a o + al(m
- m*)
+ a2(y -y*)
+ a3(r - r*) + a4D + asL ,
(10)
where a o = k/(C4C 6 +
1),
a 1 = C4C6//(C4C6
a 3 = (C2C4C 6 + C3)//(C4C6
a 5 = C4g/(C4C 6 +
-t- 1 ) ,
'}-
1),
a 4 ~- C 5 / / ( 6 4 C 6
a 2 = C L C 4 C 6 / / ( C 4 C 6 qd-
1),
1),
1),
and D = b - f. Now consider the expected behavior of the parameters of equation (10). According to the monetary model, (m - m * ) and ( r - r*) should have positive coefficients, whereas ( y - y * ) should have a negative coefficient. Through money market adjustment, the foreign exchange value of the currency of the country with relatively easy monetary policy should decrease (or e should increase). Similarly, an increase in domestic interest rates should reduce domestic demand for money, causing a decrease in the value of domestic currency. An increase in domestic real income should raise the demand for money and induce domestic currency appreciation. According to the asset model, ( r - r*) should have a negative coefficient, because capital inflows, caused by high domestic interest rates relative to foreign interest rates, induce an appreciation of the domestic currency vis-?t-vis foreign currency. This is in conflict with the expected sign from the monetary model. The sign of the coefficient of (r - r*), therefore, depends on the relative importance of money versus asset markets in a given economy. In an inflationary environment, the rate of interest is likely to be dominated by inflationary expectations rather than by liquidity effects associated with changes in the ratio of money to bonds. Therefore, a high domestic interest rate is expected to affect the domestic currency negatively. In an economy with stable monetary policy and low inflation expectations, a high domestic interest rate is likely to induce capital inflows, with a positive impact on the domestic currency.
Effect of Foreign Debt on Currency Values
335
The effect of D operates through the asset market and differs for static and dynamic analysis. In a static context, foreign debt implies captial inflows and (ceterius paribus) leads to a strong domestic currency through asset equilibrium in the capital account. 3 A dynamic version of the asset model [e.g., Dornbusch (1976) and Kouri (1976)], however, incorporates the current account imbalances and their impact on a country's holding of net foreign assets. In a dynamic context, a deficit in the current account causes an increase in the country's external debt or a reduction in net foreign assets held by domestic residents, and this has a negative effect on the external value of the domestic currency. The net effect of D on e is, therefore, ambiguous due to the conflict between the static asset equilibrium in the capital account and the dynamic effect of the current account imbalances on net asset supply. The effect of the oil price shock depends on whether a country is net exporter or importer of oil. In the short-run when the demand for oil is price-inelastic, and assuming no constraint on production capacity, an increase in the world oil prices should permit current account surpluses or international reserve accumulation for oil exporting nations and consequently the appreciation of their currencies. Oil importing nations should experience the opposite e f f e c t . 4
I l L Estimation Result The synthesized model 5 is estimated with quarterly data from the fourth quarter of 1975 to the fourth quarter of 1987 for 18 developing or moderate-income countries. The data cover a period of recent exchange rate flexibility after the 1973 oil price shock. Country selection was guided by data availability on flexible currencies in LCDs during the period and reflects our desire to present the analysis across samples from oil-exporting, oil-importing, highly indebted, moderate-income, and the newly industrialized countries. Data definitions are as follows: e is the log of domestic currency units per unit of the U.S. dollar, m is the log of money supply (M1), y is the log of industrial production index, r is the nominal interest rate measured by the three-month treasury bill rate, D is the log of cumulative domestic current account deficits during the period, and L is the oil price shock measured by the price of crude petroleum in U.S. dollars in the world market. The asterisks denote corresponding U.S. variables. Table 1 presents the estimated results. The model was estimated by ordinary least squares (OLS) and the Cochrane-Orcutt (CORC) techniques to reduce autocorrelation. The OLS results exhibit the presence of serial correlation in all but 2 of the 18 countries, whereas, the CORC techniques display lower R-squares in general.
3 This is at odds with the traditional flow view based on the balance of payments: the current account deficits, which presage the external debt, have a negative impact on the domestic currency. 4 Alternatively, the oil price shock may be interpreted as a proxy for input price uncertainty for oil-importing nations. This interpretation, however, affects the exchange rate in the same direction as the one discussed in the text. 5 A parallel exposition is offered by Sachs (1986).
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R . A . Ajayi a n d J o n g m o o Jay Choi
Table 1. E s t i m a t i o n Results e = a o + a l ( m - m * ) + a2(y - y * )
Country Brazil
Method OLS CORC
Greece
OLS CORC
India
OLS CORC
Indonesia
OLS CORC
Israel
OLS CORC
Korea
OLS CORC
Malaysia
OLS CORC
Mexico
OLS CORC
Nigeria
OLS CORC
Peru
OLS CORC
Philippines OLS CORC Portugal
OLS CORC
a0
a1
-4.7597 (-2.455) -21.5606 (-3.885) 2.057 (0.970) -6.1071 (-4.463) -3.1680 (-9.984) -3.2167 (-6.390) 6.2327 (39.280) 6.1862 (18.121) -2.7342 (-5.101) - 2.2511 (-4.068) 6.0163 (39.28) 7.2600 (2.372) 1.6132 (10.071) 2.9677 (0.422) 1.1406 (0.873) 2.2417 (1.266) -0.5518 ( - 1.561) 2.4912 (5.518) -7.3817 (-2.953) 3.7559 (0.488) - 0.5555 (-0.949) 10.9399 (2.985) 4.1411 (1.308) 3.8470 (1.247)
0.8411 (23.234) 0.7242 (11.306) 0.4311 (1.696) 0.1456 (2.268) 0.1448 (5.400) 0.0641 (1.542) -0.6624 (12.561) -0.6090 (-8.983) 1.1296 (59.800) 1.1309 (39.957) -0.3023 (-7.661) -0.1445 (-3.350) -0.2248 (-3.609) 2.9677 (-4.609) 0.7532 (6.541) 0.8757 (5.910) 0.2161 (0.9940) 0.0148 (0.089) 0.5026 (5.602) 0.1809 (11.306) - 0.3317 (-1.864) 0.1462 (1.462) 1.6205 (2.379) 1.6167 (2.473)
az
+ a3(r - r * ) + a n D + a s L
a3
a4
-0.1215 0.0075 0.7737 (-0.401) (11.077) (3.654) -0.2345 0.0033 2.3345 (-1.636) (3.609) (4.456) -0.0550 0.0504 0.3175 (-0.739) (4.032) (1.586) 0.0049 -0.0044 1.1138 (0.305) (-0.869) (7.863) -0.1659 -0.0006 0.5737 (-1.964) (-0.213) (16.226) -0.0529 -0.0066 0.5781 (-0.819) (-2.248) (11.052) 0.1533 -0.0164 -0.0311 (4.007) (30.732)(-2.550) 0.0921 • -0.0149 0.0077 (1.589) ( - 17.356) (-0.0012) 0.1616 0.0009 -0.0194 (0.269) (7.883) (-0.269) 0.4781 0.0008 - 0.0678 (0.7740) (4.826) (-1.095) 0.0194 -0.0063 0.0327 (1.066) (-10.643) (2.197) -0.0720 -0.0016 0.0030 (-2.036) (-0.188) (0.333) 0.2207 0.0136 0.0043 (6.400) (7.285) (0.772) -0.2858 -0.0185 0.0005 (-0.317) (0.167) (-0.428) -3.5350 0.0182 0.2148 (-6.087) (5.281) (1.599) -2.4777 0.0150 0.1765 (-3.569) (3.328) (0.935) -0.5743 0.0269 0.0489 (-3.249) (2.237) (1.970) -0.4211 0.0009 -0.0030 (-2.429) (0.074) (-0.212) -0.2189 0.0281 1.3946 (-0.167) (3.552) (4.679) 0.1228 0.0076 0.6169 (0.647) (1.551) (-0.204) - 0.8744 0.0230 0.5419 (-4.908) (3.949) (10.379) -0.1207 0.0096 -0.5295 (-0.871) (1.969) (-1.929) 0.2990 0.0172 0.1614 (0.303) (0.623) (0.446) 0.2089 0.0159 0.1984 (0.218) (0.599) (0.564)
a5 -0.1776 (1.069) -0.1722 (-1.302) -0.2465 (-2.938) -0.0191 (-0.361) 0.0042 (0.191) -0.0265 (-1.074) 0.0786 (2.227) 0.0506 (0.168) 0.5026 (5.852) 0.4954 3.9590 0.0798 (2.881) 0.0703 (2.342) -0.1942 (-1.172) -0.0022 (0.390) -0.0297 (-0.157) -0.1409 (-0.723) -0.2423 ( - 1.708) -0.4509 (-2.767) 0.1615 (1.528) -0.2997 (0.815) - 0.3396 (-4.914) 0.0452 (-0.678) -0.4943 (-1.742) -0.5005 (-1.836)
R2
SE
DW
0.99 0.193 0.64 0.90 0.113 1.56 0.92 0.163 0.49 0.68 0.049 2.06 0.97 0.029 0.98 0.80 0.023 1.92 0.98 0.062 0.79 0.99 0.098 1.93 0.99 0.173 1.25 0.99 0.160 2.07 0.97 0.039 0.89 0.97 0.029 1.60 0.76 0.032 1.10 0.86 0.024 1.79 0.99 0.176 1.17 0.95 0.158 1.92 0.67 0.191 0.66 0.20 0.119 1.86 0.99 0.201 0.85 0.15 0.128 1.59 0.95 0.102 0.94 0.17 0.057 2.08 0.71 0.362 2.15 0.74 0.364 2.03
337
Effect of Foreign Debt on Currency Values Table 1. (continued) Country Method Singapore
OLS CORC
S. Africa
OLS CORC
Spain
OLS CORC
Srilanka
OLS CORC
Taiwan
OLS CORC
Turkey
OLS CORC
a0
a1
az
a3
a4
a5
1.2189 (14.365) 1.3094 (14.138) - 1.6280 (-5.853) 0.5598 (0.593) 0.3850 (1.144) 2.9141 (3.493) - 0.7049 (-1.938) 2.6609 (1.789) 3.8661 (58.258) 3.5860 (17.197) 0.3287 (0.156) -19.2802 (-4.369)
-0.2385 (-4.536) - 0.2037 (-4.247) 0.7909 (9.937) -0.0137 (-0.078) 0.0822 (0.499) 0.1329 (0.686) 0.9576 (5.066) -0.2379 (-1.391) -0.2301 (-9.904) - 0.0648 (-1.747) 0.8356 (5.059) 0.1116 (0.692)
-0.1087 (-2.520) - 0.0425 (-0.988) - 0.7699 (-3.026) -0.4435 (-1.258) - 1.9296 (-8.807) -0.3644 (-1.431) - 0.1662 (-0.781) -0.0293 (-0.267) 0.1457 (2.364) 0.0312 (0.457) - 0.0441 (5.998) -0.0487 (-0.532)
0.0046 (1.364) - 0.0007 (-0.233) 0.0003 (0.052) 0.0081 (1.138) 0.0108 (2.069) 0.0007 (0.256) 0.0041 (0.335) -0.0097 (-0.967) -0.0075 (-3.254) - 0.0009 (-0.413) 0.0272 (5.988) 0.0125 (1.697)
0.0196 (1.873) - 0.0297 (-1.806) - 0.0202 (-0.800) -0.0261 (-1.532) 0.4310 (14.307) 0.1703 (2.945) 0.1479 (1.621) 0.1672 (0.953) -0.0012 (-0.209) 0.0042 (0.512) 0.2973 (1.272) 2.4024 (5.129)
-0.0095 (-0.543) 0.0350 (1.754) - 0.2466 (-2.607) 0.7647 (0.850) -0.0520 (-0.999) 0.2215 (0.371) - 0.0683 (-0.703) -0.0181 (-0.166) 0.1680 (11.458) 0.0130 (0.605) 0.1830 (1.787) 0.1113 (0.707)
R 2 SE DW 0.84 0.026 1.14 0.91 0.020 2.15 0.88 0.145 0.63 0.11 0.085 1.91 0.95 0.088 0.99 0.22 0.054 1.94 0.88 0.155 0.97 0.08 0.098 1.45 0.90 0.032 1.09 0.96 0.021 1.46 0.98 0.185 1.54 0.77 0.149 1.99
Data Sources: International Finanacial Statistics, IMF, World Debt Tables, World Bank, Statistical Abstract of Latin America, UCLA Latin American Publication, and Financial Statistics, Cenral Bank of China, Taipei. Note: Figures in Parentheses are t values; DW is the Durbin-Watson statistic; SE is the standard error of residuals.
Estimation results based on the CORC are generally consistent with model predictions. First, the coefficients of (m - m* ) are positive (on the value of foreign currency in terms of domestic currency) in 11 cases and negative in the remaining 7. In the cases where these coefficients are positive, they are also significant (at 95% on a two-tail test) in about half the cases, just like the negative ones, which are also significant in about half of the occurrences. Second, the coefficients of (y - y * ) are weakly consistent with the monetary view, because they are negative in 12 of the 18 cases. However, regardless of signs, most coefficients are statistically insignificant (15 out of 18). This result contrasts with most empirical evidence on major industrial currencies. The reason for this difference between currencies of LDCs and industrialized nations is not clear. Our conjecture is that it is a consequence of largely underdeveloped financial markets in the LDCs, so that the effect of real income is not fully captured in a monetary model. Third, the result on (r - r*) is mixed. The coefficients are positive and significant in four countries, and negative and significant in two countries. The rest have insignificant coefficients. However, the fact that the coefficients are positive in 11 out of the 18 cases is fairly consistent with the monetary model or the dynamic version of the asset model, but inconsistent with the static asset equilibrium. The static model may fail because a favorable domestic interest rate is not sufficient for
338
R.A. Ajayi and Jongrnoo Jay Choi significant capital inflows to these countries given the political risks and restrictions on currency conversion. Fourth, the debt factor has a positive impact on e (or a negative impact on the value of domestic currency) in 12 out of 18 cases. Moreover, the coefficients are positive for all five countries that are significant at the 95% level (Brazil, Greece, India, Spain, and Turkey). The explanation of this result is that, for most developing economies, the growth of external debt can be traced to prolonged current account deficits a n d / o r capital flights, with an inevitable domestic currency depreciation. These results are contrary to the static asset view, but consistent with the dynamic asset model that incorporates the current account flows. Countries with negative coefficients are exceptions, and include Singapore, Israel, and South Africa. These economies are more advanced than the others. Given their developed financial markets, their debts can be explained m the context of a static asset model, where the external debt implies excess foreign demand for domestic assets, and such a pressure enhances the external value of the domestic currency. Fifth, the oil price coefficients are not significant in 15 of the 18 cases. It is, however, noteworthy that in the remaining three cases, Nigeria, Korea, and Israel, where the coefficients are significant, the sign is negative in the case of Nigeria, an oil exporting nation, and positive in the cases of Israel and Korea which are oil importing nations. In Table 2 we present an analysis of the responsiveness of the exchange rates to the debt and oil terms across economic and geographical blocks of the sample LDCs. It is interesting to note that the currencies of the newly industrialized Asian nations of Korea, Singapore, and Taiwan (block C), on the average, show the least responsiveness to the debt and oil factors. The oil exporting countries in block A are second on this score with their currencies showing a surprisingly mild responsiveness to both debt and oil factors. On the other hand, currencies of the three Latin American countries in the sample (block D) are the most influenced (negatively) by the debt factor. These are in turn followed, respectively, by countries in block E (moderate-income Mediterranean countries) and those in block B (highly indebted nations). The oil price is generally weak and not significant across the blocks, with this effect being slightly more pronounced in the Latin American block. Debt and oil prices may be correlated enough to make their individual effects insignificant. To explore this further, we estimated the synthesized model [equation (10)] excluding either of these two terms. The model performs markedly better without the oil term than without the debt term (results not reported). Overall, the external debt and the relative money supply terms contribute the most whereas the real income and the oil price terms contribute the least in determination of exchange rates in the sample LDCs under study during the recent flexible exchange rate period.
IV. Summary and Conclusions The connection between external debt and exchange rates has not received much attention in the literature. The literature on LDC debt is primarily concerned with the debt-servicing capacity of the borrowing countries and the implication of debts from the standpoint of lenders and the international financial system. The models
Effect of Foreign Debt on Currency Values
339
Table 2. A Comparative Analysis of Debt and Oil Coefficients (from the Cochrane-Orcutt Method) Debt Block A : O i l E x p o r t i n g Countries a Indonesia Mexico
Nigeria Average
0.0077 0.1765 - 0.0030
Oil
0.0506 - 0.1409 - 0.4509 b
0.0604
- 0.1804
2.3345 b
- 0.1772
Block B : H i g h l y Indebted Countries Brazil Mexico Nigeria
0.1765 - 0.0030
Philippines Average
- 0.5295 ~ 0.4946
Block C: Newly Industrialized Asian Countries Korea 0.0030 Singapore - 0.029"?" Taiwan
Average
- 0.1409 - 0.45090 0.0452 - 0.1809
0.0703 b 0.035(/:
0.0042
0.0130
- 0.0075
0.0394
Block D: Latin American Countries Brazil
2.3345 b
- 0.1722
Mexico
0.1765
- 0.1409
Peru
0.6169
- 0.2997
1.0426
- 0.2043
Average
Block E: Moderate-Income and Mediterranean Countries Greece 1.1138 b Israel - 0.0678 Portugal 0.1984 Turkey 2.4024 b Spain
Average
- 0.0191 0.4954 h - 0.5005¢ 0.1113
0.1703 b
0.2215
0.7634
0.6172
a T h i s c o n t r a s t s with the average coefficients of 0.4622 and 0.0476 for debt and oil, respectively, in the case of 15 non-oil exporting countries in the sample. h Significant at 95% confidence interval (two-tailed test). c Significant at 90% confidence interval (two-tailed test).
of exchange rates include money, interest rates, inflation, and the balance of payments variables, but not debt. This paper examines the effect of external debt on the values of LDC currencies using a model of exchange rates that synthesizes the monetary approach and the asset view and incorporates a debt factor. The model is estimated for 18 countries and the results indicate that external debts have significant negative impact on the currency values of most of these countries. The results also show that relative money supply and interest rates are important, whereas the effects of income and oil prices are generally weak and insignificant. The result has important implications for debt and exchange rate management in the LDCs. It suggests that a coordinated management of debts and exchange rates holds greater promise of success than an independent management of these
R.A. Ajayi and Jongmoo Jay Choi
340
variables, It also underscores the need for authorities in the LDCs to pursue debt reduction measures and thereby arrest a potentially vicious cycle of debt accumulation followed by exchange rate depreciation.
References Ajayi, R. A. May 1989. Essays on oil, external debts, and optimal exchange rates in the developing economies. Unpublished Ph.D dissertation (Temple University Phila. PA). Black, S. W. December 1976. Exchange policies for less developed countries in a world of floating rates. In Essays in lntemationalFinance 119. Princeton, N J: Princeton University Press. Branson, W. H. and Henderson, D. W. 1985. The specification and influence of asset markets. In Handbook of International Economics, Vol. 2 (R. Jones and P. Kenen, eds.). Amsterdam: North-Holland, pp. 749-805. Dornbusch, R. December 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84:1161-1176. Dornbusch, R. 1980. Exchange rate economics: Where do we stand. Broolangs Papers on Economics Activity 1:143-194. Dornbusch, R., and Fischer, S. December 1980. Exchange rates and current account. American Economic Review 70:960-970. Frankel, J. 1983. Monetary and portfolio-balance models of exchange rate determination. In Economic Interdependence and Flexible Exchange Rates (J. S. Bhandari and B. H. Putnam, eds.). Cambridge, MA: MIT Press. Frenkel, J. A. May 1976. A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence. Scandinavian Journal of Economics 78:200-224. Johnson, H. G. 1973. The monetary approach to the balance of payments. In International Trade and Money (M. Connoly and A. Swoboda, eds.). London: George Allen and Unwin. Kouri, P. J. K. May 1976. The exchange rate and the balance of payments in the short run and in the long run: A monetary approach. Scandinavian Journal of Economics 78:280-304. Sachs, J. 1986. Managing the LDC debt crisis. Brookings Papers on Economic Activity 2:397-440.