High Interest Rates and Exchange Rate Stabilization in Korea, Malaysia, and Thailand: An Empirical Investigation of the Traditional and Revisionist Views Robert Dekle, Cheng Hsiao, and Siyan Wang* Abstract The paper seeks to determine whether high interest rates have had the effect of appreciating nominal exchange rates in three Asian countries.The authors use high-frequency data for Korea, Malaysia, and Thai- land during the recent crisis and its aftermath to examine the relationship between the increase in interest rates and the behavior of exchange rates. It is found that raising interest rates has had a small impact on nominal exchange rates during the crisis period. 1. Introduction The traditional view stresses that tight monetary policy is necessary to support an exchange rate: a higher interest rate raises the return that an investor obtains from investing in the country, reduces capital flight, and discourages speculation. However, several prominent economists have argued a revisionist view that a rise in interest rates has a negative effect on the exchange rate (Radelet and Sachs, 1998; Feldstein, 1998; Furman and Stiglitz, 1998). The revisionist view is that, under the unique conditions of a financial panic, tight monetary policies and high interest rates would result in capital outflows and exchange rate depreciation. That is, the high interest rates cause a financial implosion, and raise default probabilities, thus weakening the currency. Radelet and Sachs (1998, p. 31) express this view strongly: It is entirely possible that in the unique conditions of the midst of a finan- cial panic, raising interest rates could have the perverse effect of weaken- ing the currency .... Creditors understood that highly leveraged borrowers could quickly be pushed to insolvency as a result of several months of high interest rates. Moreover, many kinds of interest-sensitive market partici- pants, such as bond traders, are simply not active in Asia’s limited financial markets. The key participants were the existing holders of short term debt, and the important question was whether they would or not roll over their claims. High interest rates did not feed directly into these existing claims (which were generally floating interest rate notes based on a fixed premium over LIBOR). It is possible, however, that by undermining the profitability of their corporate customers, higher interest rates discouraged foreign investors from rolling over their loans. Review of International Economics, 10(1), 64–78, 2002 © Blackwell Publishers 2002, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA *Dekle: Department of Economics, University of Southern California, 3620 S.Vermont Ave, Los Angeles, CA 90089-0253, USA.Tel: (213)740-2134; Fax: (213)740-8543; E-mail: dekle@usc.edu. Hsiao: Department of Economics, School of Finance, University of Hong Kong; and University of Southern California. Wang: Department of Economics, University of Delaware, Newark, DE 19716, USA. We thank Menzie Chinn, Y.-W. Cheung, participants at the Seattle conference on the Asian crisis, and a referee for helpful comments.