Effect of falling real interest rates and more favourable opportunities to borrow abroad on economic growth

Joining the euro area, Hungary will be given a more favourable credit rating and may escape the costs of higher exchange rate volatility. We have attempted to capture the resulting benefits using two variables. First, domestic real interest rates will be lower due to the reduction in exchange rate risk; second, owing to the more favourable credit rating and improved capacity to repay existing debt which becomes independent of exchange rate volatility, the sustainable measure of current account deficit may be higher. Both variables allow the economy to grow at a faster rate.

The expected easing of current account deficit constraint is well illustrated by empirical studies which examined capital flows among the regions or provinces of a few large countries. As an effect of a common currency, capital flows among member states will, in principle, become as smooth as are capital flows among regions within countries of large geographical dimensions. The phenomenon that the overwhelming majority of a country's savings are invested in the given country is referred to as the ‘Feldstein-Horioka Puzzle’ in the academic literature. But, providing perfect international capital flows, there should be no relationship of any sort between the geographical locations of savings and investment – savings should be used where they produce the highest returns (at equal levels of risk). Presumably, the current account deficit plays a role in this phenomenon – its high level indicates increased devaluation risk, which acts as a factor restraining capital inflow.

With the creation of monetary union, the mobility of capital is likely to be higher, as exchange rate risk, being an important risk factor, disappears. As other factors also affect capital flows, it is not easy to isolate the expected effects of a common currency from other (regulatory, cultural, etc.) effects. The academic literature measures the expected effect by examining the interaction between savings and fixed investment, and by assuming that the common currency will create a similar relationship. The most frequently cited work is the study by Bayoumi and Rose (1993) which analysed the interaction between savings and fixed investment in the United Kingdom using various approaches. Other studies analysed the cases of Canada, Japan and the United States.¹⁰² These studies concur in their conclusion that the relationship between savings and fixed investment is much looser and, occasionally, the reverse, among the regions within a country than on a country level. In other words, the current account balance of regions does not represent a serious hurdle to capital flows. From this it follows that the magnitude of capital flows among the participating countries will be significantly higher than earlier as a result of monetary integration. Stating it differently, member countries' current account deficits are much less of an impediment to capital flows within a currency union.

In the next section, we measure the expected size of the fall in real interest rates based on information inherent in the yield curve. We quantify the effect on economic growth on the basis of two different model simulations. The effect of variations in the current account balance has been built in our estimates on an ad hoc basis, changing the parameters of the models.

IV.4.1. Expected fall in real interest rates as a result of joining the euro area

The return for foreign investors on their forint-denominated investments is determined by the nominal depreciation of the forint, in addition to the financial return achievable in their own currencies. As future developments in the exchange rate cannot be forecast perfectly, forint yields may contain a significant

102Thomas (1993), Bayoumi (1997), Dekle (1996), Sinn (1992), Iwamoto et al (2000) and Wincoop (2000).

premium of exchange rate risk which foreign investors require due to unforeseen exchange rate movements, i.e. exchange rate uncertainty. The exchange rate risk premium is the positive function of exchange rate volatility, therefore, the measure of this type of risk will cease with accession to the euro area, which, in turn, will result in a reduction in real interest rate levels. Country and liquidity (or size) risk premia are the other components of the risk premium on forint yields. In the case of Hungary, as an emerging economy, the country risk premium may also fall with accession to the EU and later to the euro area, as the exchange rate risk premium and the country risk premium are not independent of each other.¹⁰³

The size of the risk premium on forint yields, i.e. the sum of exchange rate risk premium, plus country and liquidity risk premia, can be measured as the difference between forint interest rates and euro interest rates and the expected nominal depreciation of the forint exchange rate. The sum of country and liquidity risk premia may be approximated with Hungarian foreign currency bond spreads, as these do not contain exchange rate expectations or exchange rate uncertainty components. Given that exchange rate expectations cannot be observed directly, estimating the exchange rate risk premium carries an extremely high degree of uncertainty.

In respect of measuring the exchange rate risk premium, the periods preceding and following band widening in May 2001 must be treated separately. Within the confines of the narrow intervention band, anticipated variations in the exchange rate could be approximated with the pre-announced devaluation rate of the forint over the short term, i.e. over a three-month horizon. Therefore, we have used the interest rate premium, calculated as the difference between three-month forint-euro interest rate differential and the pre-announced devaluation rate, as an approximating indicator of the risk premium content of forint yields.

103The assumption that emerging-country exchange rate risks and the default risk on foreign currency bond spreads are closely interrelated seems plausible. Explanation for this is that, in the event of a currency crisis, the likelihood of a state's default on its liabilities denominated in foreign currency rises. Consequently, in our assumption the rise in exchange rate risk premium is accompanied by a rise in foreign currency bond spreads.

However, the depreciation of the central parity did not perfectly reflect actual exchange rate expectations, as it did not contain anticipations of intra-band exchange rate movements and of a change to the exchange rate regime.¹⁰⁴

Chart IV-3