Exchange rate regime credibility, the agency cost of capital and devaluation

Abstract

Hong Kong pegs their currency to the US dollar with a currency board. In the wake of the Asian financial crisis in 1997, the US–Hong Kong interest rate differential jumped from 1 2 % to 4–6%. Investors feared Hong Kong would abandon the peg. This paper analyzes the crucial role of credibility in a stochastic dynamic rational expectations regime switch model. I parameterized the model using estimates of the exchange rate process for Hong Kong. The model generated interest rate differentials are consistent with the interest differentials in Hong Kong before the Asian financial crisis in July of 1997 but not after the crisis.