Keywords: interest rate linkages; cointegration; financial integration; error correction models JEL classification: F36

Transcription

1 Vuyyuri, S. Linkages of Indian Interest Rates LINKAGES OF INDIAN INTEREST RATES WITH US AND JAPANESE RATES VUYYURI, Srivyali * Abstract The reform process in India has gradually integrated the Indian financial markets with the rest of the world, and as a corollary, interest rates in India have been responding to movements in other financial markets. This article employs monthly short-term interest rate data over the period to investigate the influence that the Japanese and the American interests exert on interest rates in India. We use cointegration and causality tests and find the existence of a steady-state relationship of short-term interest rates in India with both US and Japan. We also briefly discuss some policy fallouts. Keywords: interest rate linkages; cointegration; financial integration; error correction models JEL classification: F36 I. Introduction Over the past decade, the subject of interest rate co-movements in financial markets in different countries has attracted the attention of a lot of researchers stimulated by the growing signs of increasing international integration between capital markets throughout the world. Greater sensitivity to worldwide economic developments have made domestic interest rates less sensitive to domestic economic conditions and monetary policy. We have observed considerable deregulation of financial markets, which has increased the flow of capital between nations. These structural changes are largely attributed to improved communication, information, and production technology, and increasing interdependence and integration of national financial and economic systems (Anoruo et al., 2002). Capital controls and other barriers to international capital mobility were substantially dismantled among industrialized nations during * S. Vuyyuri is a Doctoral Student in Economics at the University of Alberta, Canada. srivyalv@yahoo.com 19

2 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) the 70s and 80s, followed by many other European and Asian countries. Along with the liberalization of capital controls, these nations experienced many developments in their financial markets including deregulation, the introduction of new financial instruments such as currency and interest rate swaps, and a reduction in information costs. India embarked on a policy of economic liberalization in the early 1990s. Since then, the remnants of an exclusivist and closed economy have been progressively been dismantled by the government. Taking cue from its East Asian cousins, India has been consciously making efforts to attain economic efficiency and integrate with the world economy with financial liberalization and relaxing controls on international capital flows. As a result, domestic and foreign market forces have been playing a greater role in the Indian financial markets. Integration of financial markets implies that India cannot be screened away from foreign influences. This holds good for the behavior of interest rates across world markets as well. Most of the literature tried to explore the linkages in interest rates among the industrialized countries and a few more in the East Asian countries. The initial studies concentrated on the integration of financial markets in various countries with those of the US and Japanese financial markets because of the role played by them in the world economy. There have been some studies linking the movements of stock markets in India and the US (e.g. Arshanapalli and Kulkarni, 2001). Our paper studies the relationship between short-term interest rates in India with those in the US and Japan. The study and findings are especially relevant firstly, because of limited studies in India and secondly, since the relationship of Indian economy with outside world is vastly different from those of the Western and Asian economies and also since the short-term interest rates essentially capture the monetary policy in an economy. Also, the backdrop and experiences have been different; India has had to cope with a variety of problems in its journey of liberalization such as restrictive 20

3 Vuyyuri, S. Linkages of Indian Interest Rates bureaucracy and red tape, rigid labor laws, highly regulated capital markets and less political stability among others. The structure of the paper is as follows. The next section deals with the existing literature on the subject. Sections III and IV deal with methodology and empirical results. Section V discusses the empirical results and the last section provides concluding remarks. 2. Literature Review Evaluating the degree of integration between two different financial markets by testing for the equality of real interest rates across countries has attracted the attention of many researchers in the field of international finance since early 80s (e.g. Mishkin, 1984; Mark, 1985; Cumby and Mishkin, 1986; Merrick and Saunders, 1986). The initial studies used less rigorous econometric methods, but since the advent of advanced techniques like stationarity and cointegration tests, there have been studies about the long-term relationship between interest rates in various countries. In studies on money market linkages, the focus has been on two issues the relative yield on similar assets across national markets and interest rate sensitivity to financia l flows across borders (Bremnes et al., 2001). Initial studies for US markets concentrated on causal linkages with the Eurocurrency and other developed markets. There has been substantial literature for linkages among and between the US, the Japanese and the Pacific Basin countries. We shall first have a look at some studies in the Western markets. Kwack (1971) and Levin (1974) found that the US interest rates were isolated from the movements in short-term interest rates in the European markets and other world markets whereas Kaen and Hachey (1983), Schnitzel (1983) and Hartman (1984) find the existence of feedback effects between interest rates in these markets. Fukao and Okubo (1984) investigated the international interest rate linkages between Japan and the US and found that international factors such as the US interest rate and the expected change in the 21

4 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) exchange rate play an important role in the determination of Japan s domestic long-term interest rates 1. Hutchison and Singh (1997) found similar results using ex ante real interest rates. Goodwin and Grennes (1994) undertook a cointegration analysis of the linkage of real interest rates between the US and Canada and they reported that these two real interest rates are cointegrated and the real interest rate differential is stationary. Kirchgassner and Wolters (1987) include both the short-term Eurocurrency market in London and the long-term bond market to establish strong Granger causal link in interest rates between the US dollar, the German mark and the Swiss franc over the period Karfakis and Moschos (1990), examined the short-term domestic interest rate linkages within the European Monetary System (EMS) using bivariate vector autoregression analysis, and concluded that the German interest rate played a dominant role within the EMS. The results have been consistent with other studies (Edison and Kole (1995) and Borio and McCauley (1996); Fratianni and von Hagen 1, 1990; Katsimbris and Miller 2, 3, 1993). Bremnes et al. (2001) use cointegration methodology and corroborate long run co-movements between interest rates of the G5 nations the US, the UK, France, Germany and Japan for the period Monadjemi s (1997) study indicates that real interest rates among five OECD countries were cointegrated and that the smaller economies showed a significant and positive response of rates to a shock of real rates in the dominant economies but the converse was not true. Bremnes et al. (2001) found similar results for the US, Germany and Norway and causality flowing from the US to Germany and Norway without feedback effects. Let us now look at some studies that have been done for the Asian countries: Otari and Tiwari (1981), Ito (1988) and Bosner-Neal and 1 Their study used a theoretical model based on the simplified form of the international flow of funds table 2 Both these studies incorporated inflation and output growth in their models 3 The study employed trivariate Granger causality test 22

5 Vuyyuri, S. Linkages of Indian Interest Rates Roley (1994) have done research in the Japanese and the US markets exploring the cointegration of interest rates adjusted and unadjusted for exchange rates Pacific -Basin countries. Similar studies have been done for Korea, Malaysia Singapore and Thailand against the Japanese LIBOR 4 (Faruqee, 1992); Korea and Taiwan against the US (Reisen and Yeches, 1993) among others. Chinn and Frankel (1995) investigate the relative influence of US and Japanese real interest rates in the determination of local Pacific Rim rates, where influence is defined by the presence of common stochastic trends. They find evidence that Hong Kong, Malaysia and Taiwan are integrated with both the US and Japan (in terms of cointegration and positive covariation), while only Singapore is solely integrated with the US whereas Korea, and Indonesia and Thailand appear to be more closely linked with Japan. More recently, Phylaktis (1999) followed Goodwin and Grennes (1994), using cointegration techniques and impulse response functions and established a long run relationship in the comovements of real interest rates in Singapore, Korea, Taiwan and Malaysia with those of the US and Japan. Anoruo, Ramchander and Thiewes (2002) investigate the inter-market interest rate linkages across seven newly industrialized markets in Asia using short-term interest rate data over and the influence that Japan and the US exert on interest rates in the region. The results show evidence of a long run and steady state short-term interest rate and that increase in the cross-country interest rate linkages has been more prominent during the 1990s. 3. Data and Methodology Data The data employed in this study are comprised of monthly observations of short-term interest rates for India, US and Japan over the interval January 1992 through December The interest rates data for India has been collected from RBI Handbook of Indian Statistics and for the US and Japan, we have sourced the data from 4 The paper studied uncovered interest rates; the Japanese LIBOR was taken as the world interest rate 23

6 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) International Financial Statistics, IMF. The interest rates used were the 90-day Treasury Bill rate for India and the US, and the 3-month Gensaki rate for Japan. Methodological issues We employ cointegration techniques to investigate the long-run linkages and short-run dynamics across nominal interest rate series. The essence of a cointegrating relationship is that the variables in the system share a common unit root process. In other words, two series integrated of the same order are said to be cointegrated if a linear combination of these series is integrated of a lesser order. The methodology is particularly appropriate for our study since it provides a flexible and functional form for modeling interest rate behavior under a steady-state equilibrium condition. The empirical exercise consists of the following steps: (a) testing for a unit root, I (1), in each series; (b) testing for the number of cointegrating vectors in the system, provided that we cannot reject the null hypothesis of unit root in each of the time series being studied and (3) estimating and testing for the cointegrating relationship in the framework of an error correction model (ECM). 1. Unit Root Test: To test for a unit root in each series, we employ the Augmented Dickey-Fuller (ADF) (Dickey and Fuller, 1981) methodology. The tests are conducted with and without a deterministic trend (t). The general form of ADF test is estimated by the following regression where a 0 is constant, t is a deterministic trend, and enough lagged differences (p) are included to ensure that the error term becomes white noise. If the autoregressive representation of Y t contains a unit root, the t-ratio for a 1 should be consistent with the hypothesis, a 1 =0. However, the ADF test loses power for sufficiently large values of p. Consequently, an additional, alternative test posited by Phillips and Perron (PP) (Phillips and Perron, 1988), which allows weak 24

7 Vuyyuri, S. Linkages of Indian Interest Rates dependence and heterogeneity in residuals, is conducted by the following regression: where u t is serially correlated. 2. Cointegration Test: To investigate the existence of a long-term relationship between the interest rates, we explore existence of any significant long-run relationships among the variables in our model. If one time series is cointegrated with the other, then this will provide statistical evidence for the existence of a long-run relationship. Though, a set of economic series are not stationary, there may exist some linear combination of the variables which exhibit a dynamic equilibrium in the long run (Engle and Granger, 1987). We employ the maximum-likelihood test procedure established by Johansen and Juselius (1990) and Johansen (1991) 5. Specifically, if Y t is a vector of n stochastic variables, then there exists a p-lag vector auto regression with Gaussian errors of the following form: where G 1,..... G p-1 and? are coefficient matrices, z t is a vector of white noise process and k contains all deterministic elements. The focal point of conducting Johansen s cointegration tests is to determine the rank (r) of matrix G k. In the present application, there are three possible outcomes. First, it can be of full rank, (r = n), which would imply that the variables are stationary processes, which would contradict the earlier finding of non-stationarity. Second, the rank of k can be zero (r = 0), indicating that there is no long-run relationship among the variables. In instances when G k is of either 5 By treating all the variables as endogenous, this approach avoids the arbitrary choice of the dependent variable in the cointegrating equations, as in the Engle- Granger (1987) methodology. They have also been shown to have good large- and finite-sample properties (see Phillips, 1991; Cheung and Lai, 1993; Gonzalo, 1994) 25

8 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) full rank or zero rank, it will be appropriate to estimate the model in either levels or first differences, respectively. Finally, in the intermediate case when there are at most r cointegrating vectors 0 = r = n (i.e., reduced rank), it suggests that there are (n -r) common stochastic trends. The number of lags used in the vector autoregression is chosen based on the evidence provided by Akaike s Information Criterion (AIC) (see Akaike, 1974). The cointegration procedure yields two likelihood ratio test statistics, referred to as the maximum eigenvalue (?-max) test and the trace test, which will help determine which of the possibilities is supported by the data 6. Apart from examination of the long-run linkages of interest rates by cointegration techniques, we explore the short-run dynamics by performing an error correction test. The Granger Representation Theorem states that if two variables are cointegrated, the relationship can be expressed as error correction model. We first regress the first difference of each variable in the cointegration equation onto lagged values of the first differences of all the variables plus the lagged value of the error correction term (i.e. the error term from the cointegration equation in the preceding equation. The optimal lag lengths are determined by minimizing the AIC. The error correction representation conceptualizes both the short-run and long-run information in the model, and allows temporal causality to emerge from (i) coefficients of the lagged variables, and (ii) the coefficient of the lagged error correction term. The equation for estimating causality is given by 6 The trace test statistic is given by Trace = T S n i=r+1 ln(1-? i ) where? r+1,..., n are the (n- r) smallest squared canonical correlations between Y t- k and?y t series, corrected for the effect of the lagged differences of the Yt, and T is the sample size actually used for estimation. The?-max statistic is given by?- max = Tln(1-? r+1 ) Since the asymptotic distributions of the Trace and? -max test statistics follow? 2 distributions, a simulation procedure is needed to identify proper critical values for each test (see Osterwald-Lenum, 1993) 26

9 Vuyyuri, S. Linkages of Indian Interest Rates 4. Empirical Results Prior to testing for cointegration, the time series properties of the interest rate series are investigated. Tests for cointegration require non-stationary time series of the same order of integration. Table 1 reports ADF and PP test results for stationarity over the period. For the levels of the series, none of the tests rejects the null hypothesis of non-stationarity at the 5% level. After first differencing, however, all the interest rate series reject the null hypothesis of non-stationarity. Overall, the evidence suggests the presence of unit roots, i.e., I (1), in its autoregressive representation. Table 2 presents the Johansen test results for cointegration between interest rates in India and US and India and Japan. Evidence from the both the Trace and λ-max statistics, indicates existence of one significant cointegrating vector in both the cases. The results confirm the presence of a long-term equilibrium relationship among the nominal interest rate series of India with those of the US and Japan. Given the cointegration results, the next stage requires the construction of an ECM, which can help analyze short-run deviations from the long-run equilibrium interest rate relationship, and to underpin the direction of causality among the non-stationary variables (Granger, 1987). Table 3 reports the joint significance of the lagged changes of the interest rates in each equation of the ECM. We can observe that the lagged error correction terms (z t ) are positive for all the three countries in the system. The statistically significant error correction coefficient implies that the variables in the system have a strong tendency to adjust to past disequilibria. It is clearly evident from the results that movements in US and Japanese rates causally influence India s interest rates. Therefore, apart from a long run steady state relationship of interest rates in India with those in the US and Japan, the interest rate movements of in these countries influence those in India. 27

10 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) 5. Conclusion This paper examines interest rate linkages in India with the US and Japanese rates, and the existence of a causal relationship from the US and Japan with India. The study employs short-term interest rate data (that capture monetary policy) for the period January 1992 through December 2002 and applies widely applied and theoryconsistent methodologies (unit root, cointegration and VECM analyses) to investigate the issue. In recent times, the issue of interest rate transmission in the developing markets has been of great importance to portfolio managers and monetary authorities. There has not been much attention given in the literature to empirically examine the short-term interest rates Our findings indicate that interest rates in India respond well to those in US and Japan. In particular, we confirm that the national short-term interest rate linkage is a steady state, long-run phenomenon, in that they are cointegrated. We can draw some policy implications from the study. Asian economies and India, in particular, have not attracted much attention in literature in this area. The extent of integration of Indian markets with other prominent markets of the world implies that the domestic policies alone cannot determine the course of an economy; there is a need to consider the influences of foreign financial markets and extend the analysis of emerging analysis of emerging market dynamics into the global perspective. As Anorou et al. (2002) have remarked in their study, this is particularly important for banks and businesses that set rules for interest rates on deposits, and loans have to be consistent with commercial banking practices and key developments in the financial sectors of various regions in the world. References 1. Akaike, H. (1974). A new look at the statistical model identification IEEE Transactions on Automatic Control,

11 Vuyyuri, S. Linkages of Indian Interest Rates 2. Anoruo, E., Ramchander, S. and Thiewes, H.F. (2002), International linkage of interest rates: Evidence from the emerging economies of Asia, Global Finance Journal, 13, pp Arshanapalli, B., and Kulkarni, J. (2001). Interrelationship between Indian and US Stock Markets, Journal of Management Research, 1(2), pp Borio, C. E. V. and McCauley, R. N. (1996), The Economics of Recent Bond Yield Volatility, BIS Economic Paper No. 45, Bank for International Settlements, Basle. 5. Bosner-Neal, C. and Roley, V.V. 1994, "Are Japanese Interest Rate Too Stable?", Journal of International Money and Finance 13(3), Bremnes, H., Gjerde, O. and Saettem, F. (2001) Linkages among Interest Rates in the United States, Germany and Norway, Scandinavian Journal of Economics, 103(1), Bremnes, H., Gjerde, O. and Saettem, F. (1997) A multivariate cointegration analysis analysis of interest rates in the Eurocurrency market, Journal of International Money and Finance, 16(5), Cheung, Y. W., and Lai, K. S. (1993). Finite-sample sizes of Johansen s likelihood ratio tests for cointegration Oxford Bulletin of Economics and Statistics, 55(3), Chinn, M.D., Frankel, J.A., Who drives real interest rates around the Pacific Rim: the USA or Japan? Journal of International Money and Finance, 14(3), Cumby, R. E., and Mishkin, F. S. (1986). The international linkage of real interest rates: the European US connection. Journal of International Money and Finance, 5(1),

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14 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) 29. Kwack, S.Y. (1971) The structure of international interest rates: An extension of Hendeshott s test. Journal of Finance, 26(4), Levin, J. H. (1974). The Eurodollar market and the international transmission of interest rates. Canadian Journal of Economics, 7, Mark, Nelson C A Note On International Real Interest Rate Differentials," Review of Economics and Statistics, 67(4), Merrick, John J., Jr. and Anthony Saunders. (1986) "International Expected Real Interest Rates: New Tests Of The Parity Hypothesis And U.S. Fiscal Policy Effects," Journal of Monetary Economics, 18(3), Mishkin, Frederic S. (1984) "The Real Interest Rate: A Multi- Country Empirical Study," Canadian Journal of Economics, 17 (2), Monadjemi, M. (1997), "International Interest Rate Linkage: Evidence from OECD Countries", International Review of Financial Analysis, 6(3), Osterwald-Lenum, M. (1992). A note with quantiles of the asymptotic distribution of the likelihood cointegration rank test statistics: four cases. Oxford Bulletin of Economics and Statistics, 54(2), Otani, I. and S. Tiwari, 1981, "Capital Controls and Interest Rate Parity", Staff Papers, International Monetary Fund 37. Phillips, P. C. B. and Perron, P. (1988) Testing for a unit root in time series regression, Biometrika, 75(2),

15 Vuyyuri, S. Linkages of Indian Interest Rates 38. Phylaktis, K. (1999). Capital market integration in the Pacific Basin region: an impulse response analysis. Journal of International Money and Finance, 18, Reisen, H. and H. Yeches, 1993, "Time-Varying Estimates on the Openness of the Capital Account in Korea and Taiwan", Journal of Development Economics, 41(3), Schnitzel, P. (1983) Testing for the direction of causality between the domestic monetary base and the Eurodollar system, Weltwirtschaftliches Archiv, 119(2), Tables Table 1. Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) Unit Root Tests Countries ADF PP Levels Differences Levels Differences Lags India Tµ = Tµ= -5.98* Z(a * ) = Z(a * ) = * 3 Tt = Tt = -6.23* Z(t a* ) = Z(t a* ) = * United States Tµ = Tt = Tµ = -6.78* Z(a * ) = Tt = -5.43* Z(t a* ) = Z(a * ) = * Z(t a* ) =- 7.65* 3 Japan Tµ = - Tµ = -5.33* Z(a * ) = Z(a * ) = * Tt = Tt = -4.67* Z(t a* ) = Z(t a* ) = * *5 percent significance level. Tµ = without trend. Tt = with trend. The critical values at the 5% significance level are and -3.41, respectively, for without trend and with trend. The lag lengths are determined by AIC. 33

16 Applied Econometrics and International Development. AEEADE. Vol. 4-2 (2004) Table 2 Johansen Cointegration Tests? -max Test Statistic Trace Test Statistic Null Hypothesis India and US India and Japan India and US India and Japan r = * * * * r = * indicates statistical significance at the 5 percent level Table 3 Causality Tests: F Statistics Dependent z t-1(error correction term) India Japan US Variable India 5.43 ** 3.67 ** 7.89 ** 8.42 ** Japan 8.56 ** ** 0.57 US 9.12 ** ** * indicates statistical significance at the 5 percent level Journal published by the Euro-American Association of Economic Development. 34