A double-edged sword: high interest rates in capital control regimes

Abstract

This paper describes the relationship between central bank interest rates and exchange ratesunder a capital control regime. Higher interest rates may strengthen the currency by inducingowners of local currency assets not to sell local currency offshore. There is also an effect thatgoes in the opposite direction: higher interest rates may increase the flow of interest income toforeigners through the current account, making the exchange rate fall. The historical financialcrisis in Iceland provides excellent testing grounds for the analysis. Overall, the Icelandicexperience does not suggest that cutting interest rates in small steps from a very high level islikely to make a currency depreciate significantly in a capital control regime, but it highlightsthe importance of effective enforcement of the controls.