www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 Uncovered Ineres Pariy and Moneary Policy Freedom in Counries wih he Highes Degree of Financial Openness Yuniaro Hadiwibowo Graduae School for Inernaional Developmen and Cooperaion, Hiroshima Universiy and Minisry of Finance of he Republic of Indonesia E-mail: yhadiwibowo@gmail.com Absrac This sudy reviews he uncovered ineres pariy hypohesis in perfecly open economies. To mee he assumpion of perfec capial mobiliy, we only include counries and periods wih he highes degree of capial accoun openness in he sample. Using several specificaions from he resriced o he less resriced models, we esimae he relaionship among exchange rae, domesic and benchmark ineres raes. Regardless of he exchange rae regime, we find evidence ha domesic ineres rae is highly sensiive o inernaional ineres rae. Therefore, moneary policy independence would be affeced. Keywords: Uncovered ineres pariy, Moneary policy, Exchange rae, Capial accoun openness Inroducion Uncovered ineres pariy (UIP) is an imporan building block of many heoreical models, bu a vas number of empirical ess fail o find supporing evidence (Alper e al., 9). In addiion o he exisence of arbirage, commonly UIP is esed joinly wih hree more assumpions, i.e. free capial mobiliy, raional (unbiased) expecaion and risk neuraliy. The failure of hese assumpions may conribue o he failure of UIP es (Moniel, 199). Firs, capial accoun may no always be as open as assumed. When capial is no freely mobile, exchange rae and ineres rae may no adjus o he reurn differenials. Secondly, UIP may also fail because of he failure of he raional expecaion. Because of he daa availabiliy, he expeced exchange rae is usually se o he ex-pos exchange rae. If exchange rae is deermined by oher facors, he use of ex-pos exchange rae could cause he deviaions from UIP. Finally, he differen risk percepions beween domesic and foreign ineres raes may also influence he evidence. This sudy uses several empirical mehods o review he UIP concep. The capial accoun openness assumpion could no be esed independenly because i is inheren in he UIP concep. Therefore, we limi he sample only for counries and periods wih he highes degree of capial accoun openness o mainain he free capial mobiliy assumpion. Risk neuraliy is anoher componen of he UIP. By resricing he sample o ensure capial accoun openness, we may es he risk neuraliy par of he UIP ogeher wih he raional expecaion. The res of he paper is organized as follows. Secion presens he mehodology. The resul and discussion are presened in Secion 3. Finally, secion concludes. Mehodology and Daa If capial is freely mobile, he exisence of arbirage equaes domesic and foreign reurn. UIP hypohesis can be expressed as he relaionship among domesic ineres rae (id ), foreign ineres rae (if ) and expeced depreciaion (s +1 /s ): s (1) 1 if 1 1 id s or in logarihmic erms lrd lrf lfx () where lrd denoes domesic reurn, lrf is foreign reurn and lfx is expeced depreciaion. We es his relaionship using several economeric models as follow: lfx lrd lrf (3) lrd lfx lrf () lfx 1 lrd lrf (5) lrd 1 lrf lfx () Flood and Rose () and Chinn () esimae Eq. (3) as he es for UIP wih he null hypohesis of = 1. Foreign exchange marke efficiency is he focus of aenion. Wihou reliable esimaes of he expeced exchange rae, empirical lieraures usually use ex-pos exchange rae. Therefore, his model is esing he join hypoheses of Published by Canadian Cener of Science and Educaion 77
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 UIP and raional expecaion. The rejecion of he null hypohesis migh be caused by several facors. Besides he openness of he capial accoun, he exchange marke inefficiency or oher facors may affec he exchange rae movemen. Nex, here migh be differen risk percepion for he increase of domesic and foreign ineres rae. Moreover, if he exchange rae regime is hard peg or credibly managed, he expeced depreciaion would be zero, consan or exogenously deermined by he cenral bank. In his case, puing he expeced depreciaion as dependen variable would be inappropriae. Therefore, he cause of he deviaion in his specificaion may vary. Frankel and Okongwu (1995) employ Eq. () o measure he perfec subsiuabiliy beween domesic and foreign asses wih he null hypohesis of = 1. In his specificaion, he focus is on he expeced local asses reurns. In his specificaion, expeced depreciaion is combined ino domesic reurn. In his case, he esimaion on he hard peg or managed regime would be possible. However, he problem wih raional expecaion may sill affec he dependen variable. The las wo equaions are less resriced han he previous wo in he sense ha each parameer is allowed o be differen. Eq. (5) corresponds o Eq. (3) if we pu resricion = - 1. The difference is ha Eq. (5) allows differen impacs of domesic and foreign ineres rae. We may obain evidence of he foreign exchange marke efficiency or he raional expecaion hypohesis if his specificaion could esablish significan relaionship. If he parameers of domesic and foreign ineres are differen, i may imply he difference in he perceived risk beween domesic and foreign ineres raes. Eq. () disinguishes he impacs of foreign ineres rae and expeced depreciaion. Eq. () corresponds o resricion = 1 in Eq. (). In his sense, we could ge he relaionship beween domesic and benchmark ineres rae separaely from he expeced depreciaion. We focus our aenion on 1 and. If domesic ineres raes follow he movemen of he benchmark raes, β 1 should equal o uniy. In addiion, we also apply dynamic specificaion o esimae shor-run and long-run relaionships: lrd lrf lfx ( lrd lrf lfx ) (7) 1 1 1 1 1 In his specificaion, indicaes he shor-run relaionship and signifies long-run or level relaionship. The parameer measures speed of adjusmen of domesic ineres rae owards he long-run equilibrium. If domesic ineres rae responds o minimize deviaions from he long-run equilibrium, should be negaive. This paper employs daa from Inernaional Financial Saisics of he Inernaional Moneary Fund. Addiional ineres rae daa are also obained from he Cenral Bank of Denmark and Bank Indonesia. We use monhly money marke raes for domesic raes (B..ZF...) because hey reflec he marke forces beer han oher raes. For he benchmark rae, we use U.S. Treasury Bill rae (Noe 1). Ex-pos exchange raes are used because he appropriae ex-ane expecaions of fuure exchange raes are unobservable. Exchange raes are expressed in erms of domesic currency per U.S. dollars. As he sample, we choose counries and periods wih he highes degree of he openness of he capial accoun according o KAOPEN index of Chinn and Io (). The sample coverage is dicaed by he availabiliy of he daa. We include counries wih more han nine years of daa. The final sample consiss of 1 counries. Based on he acual exchange rae following Levy-Yeyai and Surzenegger (5) and Frankel e al. (), we classify Bahrain, Hong Kong, Indonesia and Lihuania under he managed regime and oher foureen counries under he floaing regime. Resul and Discussion Firs, we plo domesic ineres raes wih benchmark ineres raes for each counry (Figure 1). The periods and scale for each counry is differen. We only include he periods wih he highes degree of capial accoun openness in each counry. From he figure, we may see ha he movemens of he domesic ineres raes are quie similar wih he benchmark ineres rae in some counries. The resul is presened in Table 1-3. The daase is he same. Therefore, we only pu he informaion on he period and number of observaion in he firs able. The sandard errors are robus o boh heeroskedasiciy and auocorrelaion. The upper par shows he esimaion on a counry-by-counry basis. The lower par pools he daa across counries. Table 1 presens he resuls from Eq. (3) and Eq. (). We sar wih he Eq. (3) which is commonly used in UIP es. The resul is similar wih he previous lieraures. The coefficiens of ineres differenials are no significan in almos all counries. Only one has posiive and significan value of. In he pooled analysis, managed regime has posiive value of, while floaing regime has marginally significan negaive value of. Foreign ineres raes do no have significan relaionships wih he domesic reurns adjused for expeced depreciaion in he nex model (Eq. ()), excep in hree counries. Two counries are under managed regime, Bahrain wih hard peg and Hong Kong wih Currency Board Sysem. Anoher one is Canada wih floaing regime. Eq. (5) also fails o provide he expeced resuls (Table ). Two counries have only weakly significan coefficien of domesic ineres, one of hem has he incorrec sign. All significan coefficiens of he benchmark rae have he incorrec sign. Pooled analysis produces significan parameers, bu he sign is also incorrec. 7 ISSN 19-971X E-ISSN 19-97
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 The resuls of he Eq. (3) and Eq. (5) indicae ha foreign exchange marke is no efficien or a leas does no respond o changes in domesic and benchmark ineres raes as expeced. The movemen of he exchange rae is deermined by facors oher han ineres raes. The fourh model (Eq. ()) reveals ineresing resuls. Excep for wo counries, he coefficien of foreign ineres rae is posiive and highly significan in all counries. In he pooled esimaes, we find ha he slopes are no saisically differen from uniy. The hypoheses of β = 1 could no be rejeced wih 5% confidence level. However, he coefficiens of exchange rae are no significanly differen from zero in all individual counries and pooled esimaes. Table 3 presens he resuls of dynamic specificaion (Eq. (7)). All coefficien of he foreign ineres rae is posiive wih 13 ou of 1 are significan. Pooled daa esimaes are also significan and no saisically differen from uniy in boh managed and floaing regimes. However, he managed regimes seem o adjus more rapidly wih half-life of 1 monh compared o he floaing regimes wih half-life of five monhs. Moreover, floaing regimes have smaller R value han managed regimes. This implies ha facors oher han he inernaional ineres rae have more influence on floaing regimes han managed regimes. Alhough he objecives and variables are no exacly he same, our resuls are in line wih Frankel e al. () and Shambaugh (). They find ha ineres raes are converging in he long-run, regardless of he foreign exchange regime. The differences beween fixed and floaing regime are on he adjusmen speed and R value. The resuls indicae ha domesic ineres raes follow he movemen of benchmark ineres raes, bu exchange raes do no adjus o his movemen. In his case, moneary policy freedom would be affeced. However, his should no be inerpreed ha he expeced depreciaions do no maer a all. Domesic ineres raes may adjus according o he ex ane expeced depreciaion, bu may no reflec he ex pos depreciaion. On he conrary, exchange rae may be deermined by oher facors. Therefore, deviaions from he ineres raes prediced value may happen. Conclusions This sudy uses several empirical mehods o es he UIP hypohesis. To emulae he perfec capial mobiliy, we include only counries and periods wih he highes degree of capial accoun openness in he sample. We find ha exchange raes do no reflec domesic and inernaional reurns. However, we find close long-run relaionships beween domesic and inernaional ineres raes. UIP hypohesis holds in he sense ha domesic ineres raes adjus o he benchmark ineres rae. I applies regardless of he currency regime. Therefore, a complee moneary policy freedom migh no be aainable. Acknowledgemen The auhor would like o hank Prof. Komasu Masaaki for invaluable commens and suppor. References Alper, C. E., Ardic, O. P. & Fendoglu, S. (9). The economics of he uncovered ineres pariy condiion for emerging marke. Journal of Economic Surveys, 3, 115-13. Chinn, M. D., & Io, H. (). A new measure of financial openness. Journal of Comparaive Policy Analysis: Research and Pracice, 1, 39-3. Chinn, M. D. (). The (parial) rehabiliaion of ineres rae pariy in he floaing rae era: Longer horizons, alernaive expecaions, and emerging markes. Journal of Inernaional Money and Finance, 5, 7-1. Engle, R. F. & Granger, C. W. J. (197). Co-inegraion and error correcion: Represenaion, esimaion, and esing. Economerica, 55, 51-7. Flood, R. P. & Rose, A. K. (). Uncovered ineres pariy in crisis. IMF Saff Papers, 9, 5-. Frankel, J. A. & Okongwu, C. (1995). Liberalized porfolio capial inflows in emerging markes: Serilizaion, expecaions, and he incompleeness of ineres rae convergence. Naional Bureau of Economic Research Working Paper, 515. Frankel, J. A., Schmukler, S. L. & Serven, L. (). Global ransmission of ineres raes: moneary independence and currency regime. Journal of Inernaional Money and Finance, 3, 71-733. Levy-Yeyai, E. & Surzenegger, F. (5). Classifying exchange rae regimes: Deeds vs. words. European Economic Review, 9, 3-35. Moniel, P. J. (199). Capial mobiliy in developing counries: Some measuremen issues and empirical esimaes. World Bank Economic Review,, 311-35. Shambaugh, J. C. (). The effec of fixed exchange raes on moneary policy. Quarerly Journal of Economics, 119, 31-35. Noes Noe 1. Oher benchmark raes, such as U.S. LIBOR dollar rae and Fed Rae, are highly correlaed wih he U.S. Treasury Bill rae. We also experimened wih hese raes and he resuls were similar. Published by Canadian Cener of Science and Educaion 79
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 Table 1. Expeced depreciaion and domesic reurn adjused for expeced depreciaion esimaion lfx = + (lrd - lrf ) lrd - lfx = + lrf No Counry Period T R R 1 Ausralia 19:1-199: 13.95 -.5. -3.93.1.11 (.) (1.1) (1.) (.1) Bahrain 195:7 - : 5...1.1 *** 1.1 ***.9 (.) (.) (.) (.1) 3 Canada 1975:1 - : 1.3 -...9.75 **.13 (1.3) (.5) (.5) (.33) Denmark 199:1 - : 19-1.7 -.3.1 13.3 ** -1.9.9 (.) (.9) (5.97) (1.9) 5 Euro 1999:1 - : 11-3.73 -.5 **..1 ** -.9.5 (.95) (.) (.9) (1.) Germany 197:1-199:11 37-3.7 -.53. 1. ** -.1.3 (.9) (.) (5.93) (.5) 7 Hong Kong 199:1 - : 17.7 -.. -.57 1. ***.51 (.9) (.5) (.3) (.11) Indonesia 193:1-1995: 15 5.91.9.. -.. (3.3) (.3) (.13) (1.37) 9 Japan 193:1-199: 1-1. *** -.7.19 1.9 ** -1.5.7 (.) (1.) (.95) (1.) 1 Kuwai 1979:1-199: 13.19 -.. 7..9. (1.7) (.5) (.) (.) 11 Lihuania 199:1 - : -5.3 *** -.11. 1.11 ** -1.9. (.13) (.7) (5.7) (1.) Malaysia 19:1-199: 13.93 -.31.5 1.3 * -.7.1 (1.71) (.9) (5.) (.7) 13 Neherlands 191:1-199:11 15-1. -1..9 11.1 -.5. (3.1) (1.1) (7.7) (1.9) 1 New Zealand 19:1 - :.19 -.1.. *** -1..1 (.39) (1.) (5.) (1.15) 15 Peru 1997:1 - : 13-1..55 **.31.5.9.9 (1.73) (.) (.1) (.3) Singapore 19:1 - : 31-3.91 ** -1. *.11 3.5 *.35. (1.91) (.) (1.) (.3) 17 UK 193:1 - : 3.7-1....3.1 (.1) (1.) (5.) (1.11) 1 Vanuau 19:5-199: 15 1.35.1. 3.7.5. (3.) (1.5) (.73) (1.7) Pooled Managed Regime 71.3 *.37 ***.1 3.7 *.3.7 ( counries) (.1) (.) (.) (.9) Floaing Regime 9 -. *** -.5 *..35 *** -..3 (1 counries) (.3) (.7) (1.5) (.) All Counries 39 -.5 -. *.11 7.5 *** -.1.5 (1 counries) (.5) (.) (1.37) (.5) Noes: *, ** and *** represen 1%, 5% and 1% levels of significance, respecively. Sandard errors repored in parenheses are robus o heeroskedasiciy and auocorrelaion. ISSN 19-971X E-ISSN 19-97
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 Table. Less resriced specificaion for expeced depreciaion and domesic reurn esimaion lfx = + 1 lrd + lrf lrd = + 1 lrf + lfx No Counry R R 1 Ausralia -.7-1.3 3.. -3. ***.3 *** -.1.79 (.15) (1.37) (3.97) (1.11) (.) (.1) Bahrain....3.15 *** 1.1 *** -.7.9 (.) (.) (.) (.) (.1) (1.9) 3 Canada -1.7 -.79 * 1.31 **.1.7 * 1.15 *** -.1.7 (.53) (.5) (.59) (.3) (.) (.1) Denmark -1.7.1.17.11 3.9 ***...17 (.5) (1.) (1.5) (.9) (.1) (.1) 5 Euro -.1 -.39.5 **..15 ***.31 ***..319 (11.) (3.9) (1.99) (.) (.7) (.) Germany -11.5 *.1 1.1.7 3.1 ***. ***..17 (.5) (.97) (.95) (.79) (.1) (.) 7 Hong Kong -.1 -...3 -. ** 1.1 *** -.3.71 (.7) (.) (.1) (.) (.7) (.5) Indonesia -3.1.55..5 7.7 ***. ***..159 (.3) (.73) (.9) (1.9) (.9) (.) 9 Japan -1.9 -.3 3.1 *..9 ***.7 ***..31 (9.7) (.31) (1.7) (.3) (.) (.) 1 Kuwai -3.7.7.1.9 3.5 ***.5 ***..55 (5.1) (.) (.53) (.7) (.) (.1) 11 Lihuania -13.7 **. 1.1. 1.7 ***. ***..3 (.57) (.9) (1.1) (.3) (.) (.) Malaysia -.53..7.13.3 *** -... (5.93) (.57) (.7) (1.19) (.1) (.) 13 Neherlands -.39-1.35 1.3.9 3.71 ***.37 ***..19 (.1) (1.51) (1.) (.9) (.) (.) 1 New Zealand -11.1 ** -.5 3.9 *..93 *** 1.13 ***..51 (5.55) (.99) (1.) (.53) (.13) (.) 15 Peru -.. *.3.35 -.3. ***..3 (.79) (.7) (.3) (.) (.3) (.3) Singapore -3. ** -1.1 1. *.11 -.15.75 *** -.1.77 (1.79) (1.1) (.91) (.19) (.) (.) 17 UK -1.13-1.5.3.11.1 *** 1. *** -.1.5 (.9) (1.) (1.71) (.55) (.13) (.1) 1 Vanuau.5. -.11. 5.3 ***.19 ***..73 (1.) (1.) (1.7) (.) (.5) (.) Pooled Managed Regime -.3.37 ***.9.3 1. *** 1. ***. ***.79 ( counries) (.13) (.1) (.3) (.) (.1) (.) Floaing Regime -5.5 *** -.35 1.1 ***.11. ***.7 ***. *.93 (1 counries) (1.3) (.5) (.) (.73) (.13) (.) All Counries -.9 *** -.5 1.1 ***.15. ***.1 ***..51 (1 counries) (1.15) (.) (.) (.) (.) (.) Noes: *, ** and *** represen 1%, 5% and 1% levels of significance, respecively. Sandard errors repored in parenheses are robus o heeroskedasiciy and auocorrelaion. Published by Canadian Cener of Science and Educaion 1
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 Table 3. Dynamic specificaion lrd = + 1 lrf + lfx + (lrd -1-1 lrf -1 - lfx -1 ) No Counry R 1 Ausralia -.37 ***.7 ***. -. ** 3. *** -.5.315 (.13) (.15) (.) (.) (.9) (.3) Bahrain. ** 1.5 *** -.5 -. *** 1.13 ***. ***.1 (.3) (.9) (.) (.) (.) (.79) 3 Canada -..3 -.1 * -.7 *** 1.9 *** -. **. (.11) (.13) (.) (.7) (.7) (.1) Denmark.1.3. -.3.99 -.. (.) (.) (.) (.) (.) (.) 5 Euro -.7 *. ***. -.1 5.51 -.7.359 (.) (.) (.) (.) (1.9) (.) Germany... -. ***.55 ***..7 (.19) (.1) (.) (.) (.13) (.1) 7 Hong Kong -. **. *** -.5 -.1 *** 1. *** -.5 **.33 (.19) (.) (.) (.1) (.) (.1) Indonesia 3.9 ** 1.11. -. ***. **.1.9 (1.55) (1.17) (.) (.) (.37) (.1) 9 Japan -. **. *. -. * 1.1 **.1.15 (.7) (.7) (.) (.) (.) (.3) 1 Kuwai.5 *.1 ***. -.17 ***. ***.5 *.9 (.) (.1) (.) (.5) (.1) (.3) 11 Lihuania.3 * -.71. -.31 ***.7 ***..17 (.) (.) (.) (.) (.) (.1) Malaysia.97 -.31. -. ***.15.5.1 (.) (.) (.1) (.7) (.5) (.5) 13 Neherlands -.7. ***. -. 1.1 -..7 (.13) (.5) (.) (.) (1.5) (.) 1 New Zealand.1.9 *. * -.5 ** 1. *** -.5.5 (.9) (.15) (.) (.) (.9) (.3) 15 Peru -.15.1 -.1 -. ***.3 ***.11.13 (.3) (.) (.1) (.) (.7) (.) Singapore -..3. -.1 ***.75 ***..5 (.) (.) (.) (.) (.7) (.5) 17 UK.7.9. -. *** 1.9 ***.1.59 (.) (.1) (.) (.) (.3) (.) 1 Vanuau.3 ** -.. -.11 **.17 -.1.5 (.7) (.1) (.) (.5) (.) (.) Pooled Managed Regime. ***. **. *** -. *** 1.1 ***..3 ( counries) (.19) (.3) (.) (.3) (.1) (.) Floaing Regime..1 ***. -.1 ***.99 ***..9 (1 counries) (.) (.) (.) (.) (.15) (.1) All Counries.. ***. -.15 ***.93 ***..9 (1 counries) (.13) (.7) (.) (.) (.13) (.) Noes: *, ** and *** represen 1%, 5% and 1% levels of significance, respecively. Sandard errors repored in parenheses are robus o heeroskedasiciy and auocorrelaion. ISSN 19-971X E-ISSN 19-97
www.ccsene.org/ijef Inernaional Journal of Economics and Finance Vol. 3, No. 1; February 11 1 1 UK 195 199 1995 5 Japan 9 9 9 Bahrain 199 1995 5 Singapore 195 199 1995 5 1 Denmark 9 9 9 9 Euro Area Kuwai 9 Vanuau 9 9 9 9 9 15 1 5 Germany 7 75 5 9 95 Ausralia 19 199 199 199 199 199 Hong Kong 9 9 9 Lihuania 199 Domesic Ineres (%) Benchmark Rae (%) 15 1 5 5 3 1 Neherlands 9 9 9 9 9 Ne Zealand 199 1995 5 Indonesia 9 9 9 5 15 1 Canada 5 3 1 75 5 9 95 5 Peru 9 Malaysia 19 19 19 19 199 199 Figure 1. Domesic and Benchmark Ineres Raes Noes: The period and scale for each counry are differen. Published by Canadian Cener of Science and Educaion 3