THE BURDEN OF DEBT: AN EXPLORATION OF INTEREST RATE BEHAVIOR IN LATIN AMERICA

Abstract

What determines the behavior of interest rates in Latin America? Is the recent sharp reduction in rates in the region just a transitory deviation from much higher long‐term rates? To answer these questions, this study raises two main hypotheses. First, external debt plays a central role in the sustainable behavior of domestic interest rates because it explains country risk. Second, country risk provides valuable information for predicting the behavior of exchange rate risk and not the other way around. Econometric tests confirm these hypotheses and lead to an important conclusion: unless important reforms (leading, for example, to improved tax‐collecting capacity or deeper local financial markets) are undertaken, highly indebted/high country‐risk economies will tend to be associated with high domestic interest rates. ( JEL E43, G15, 016, 054, C22)