In order to preserve external stability under macroeconomic imbalance, the Greek monetary authorities have maintained certain restrictions on short-term capital flows to insulate domestic interest rates from speculative attacks. In Discussion Paper No. 804, Research Fellow Nicos Christodoulakis and Nicos Karamouzis examine the one-month Eurodrachma offer rate and the overnight average interbank domestic rate at the end of each month during May 1987-April 1992. They show that capital controls shielded domestic interest rates from the fluctuations associated with devaluation expectations, in particular before the three general elections of 1989-90. While the mean value of the interest rate differential was 6.51 percentage points, it rose to more than 30 percentage points at the end of June 1989. Similar daily data for May-July 1989, which witnessed political uncertainty over the election of 18 June and the failure to form a stable government for several weeks thereafter, reveal a steady widening of the interest rate differential, which collapsed with the formation of a coalition government in early July. Capital controls also reduced the relative volatility of onshore rates: the Eurodrachma interest rate was almost four times more volatile than the domestic overnight rate and its spread three times greater.

Christodoulakis and Karamouzis note that the Bank of Greece could contain the crisis during this period without raising domestic interest rates through daily interventions in the currency markets. This mix of policy instruments proved ineffective in the more liberalized environment of the September 1992 EMS crisis, however, when the Bank for the first time had to raise its official domestic interest rates substantially to avert a devaluation. They finally examine the Greek authorities' responsiveness to world interest rates during May 1987-April 1992, which witnessed the gradual removal of controls on inflows and medium- and long-term outflows of capital. Their econometric tests for three-month domestic Treasury bill and foreign Euromarket rates suggest that the dependence of domestic on foreign interest rate movements increased.

Financial Openness and the Effectiveness of Capital Controls in Greece
Nicos M Christodoulakis and Nicos V Karamouzis

Discussion Paper No. 804, July 1993 (IM)