The Dynamics and Causes of Real Interest Rate Differentials: An Investigation for Developed and Emerging Markets PhD Project Alex Luiz Ferreira Supervisors: Dr. Miguel A. León-Ledesma & Prof. Roger Vickerman Department of Economics, University of Kent, UK

Thesis

Is there any evidence of real interest rate differentials in a set of emerging and developed economies? Yes What are the underlying causes of the differentials?

Motivation and Relevance  Interest Payments versus Income Growth: Default Possibility  Public Accounts: Interest Payments versus other Expenditures  Market Integration  Independent Monetary Policy  Mixed evidence: Pioneers are Mishkin (1984) and Cumby and Obstfeld (1984)

Structure of the Thesis –Chapter 1. Real Interest Rate Parity: Theory and Evidence  Literature Review –Chapter 2. Does the Real Interest Rate Parity Hold? Evidence for Developed and Emerging Markets  First Research Question –Chapter 3. The Dynamics of Interest Rate Differentials  Blanchard and Quah (1989) variance decomposition –Chapter 4. Breaking Down UIRP: Risk and Uncertainty –Chapter 5. Investigating the Causes of Default Risk and Exchange Rate Uncertainty

Paper

Does the Real Interest Parity Hypothesis Hold? Evidence for Developed and Emerging Markets Department of Economics, University of Kent, UK Alex Luiz Ferreira Miguel Leon-Ledesma Working Paper 0301

Is there evidence of real interest rate equalisation in a sample of developed and emerging markets in the recent period of liberalised trade and capital flows? How does the behaviour of the two groups of countries compare? Are there any patterns that may explain their different behaviour?

Motivation and Contribution –Mixed evidence and Default Possibility –Market Integration  focus on post liberalisation period (from 1995:3 to 2002:5)  inclusion of emerging markets: Argentina, Brazil, Chile, Mexico and Turkey  Countries supposed to be well integrated: France, Italy, Spain and UK; Germany and USA as reference countries –Techniques  Few Unit Root Tests: Meese and Rogoff (1988), Edison and Pauls (1993) and Obstfeld and Taylor (2002); Advantage over Cointegration.  More Powerful Techniques –KPSS (1992), ERS (1996), Elliot (1999) –Structural Breaks - Perron (1997)  Asymmetries are Taken into Account – M-Tar Model

Real Interest Rate Parity Hypothesis (RIPH) Explosive Unit Root Persistent or Short-Lived Permanent RIPH General Stochastic Process

rids 3 month compounded yield on Treasury Bill or Dep. Rates; CPI

rids

rids

Unit Root Tests Unit Root Tests ADFKPSSERS Elliot (1999) Country - Reference lagst-ratio DF-GLS DF-GLS u Argentina – US * 0.389* Argentina – Ger * 0.411* Brazil – USA * * * * * * Brazil – Ger * * * * * * Chile – US * 0.179* * * Chile – Ger * 0.260* Mexico – US * * 0.239* 0.239* * * * * Mexico – Ger * * 0.222* 0.222* * * * * Turkey – US * * 0.078* 0.078* * * * * Turkey – Ger * * 0.067* 0.067* * * * * France – US * 0.186* France – Ger * 0.199* Italy – US Italy – Ger Spain – US Spain – Ger UK – US * UK – Ger * *0.222* * * (US) (Ger) *

Country – Reference Lags Break Date T-ratio Argentina – US 92001: Argentina – Ger 92001: Brazil – US 01995: * Brazil – Ger 01995: * Chile – US 01998: * Chile – Ger 21997: * Mexico – US 11998: * Mexico – Ger 11998: * Turkey – US 31999: * Turkey – Ger 11999: * France – US : France – Ger : Italy – US : * Italy – Ger 91997: * Spain – US 91997: Spain – Ger 91997: * UK – US 91998: UK – Ger : * (US) (Ger) 71996: Structural Break - Perron (1997)

Half Lives (months) Half Lives (months) Country – Reference ADF Structural Break Argentina – US Argentina – Ger Brazil – USA Brazil – Ger Chile – US Chile – Ger Mexico – US Mexico – Ger Turkey – US Turkey – Ger France – US France – Ger Italy – US Italy – Ger Spain – US Spain – Ger UK – US UK – Ger (US) (Ger)

Equilibrium Levels Equilibrium Levels ADF Structural Break Country – Reference Period 1 Period 2 Argentina – US *10.42 Argentina – Ger *9.9 Brazil – USA 3.82*11.10*3.92* Brazil – Ger 3.87*11.54*4.12* Chile – US 0.98**1.05*0.74 Chile – Ger 1.12**1.37*1.13 Mexico – US 1.37*1.12*1.64 Mexico – Ger 1.25*1.35*1.73 Turkey – US 4.44*4.70*4.22 Turkey – Ger 4.95*5.09*4.19 France – US France – Ger Italy – US *-0.17* Italy – Ger Spain – US *-0.34* Spain – Ger *-0.26* UK – US UK – Ger 0.35* (US) (Ger) 0.15**00.19

M-TAR model CountryARGUSARGERBRAUSBRAGERCHIUSCHGERMEXUSMEXGERTURUSTURGER λ m μ1μ1μ1μ (-0.055)-0.177(-0.524)1.679(1.829)2.468(2.572)1.428(2.610)1.358(2.389)0.687(2.421)0.643(2.237)3.027(2.997)5.956(3.196) μ2μ2μ2μ (-1.867)-0.187(-0.515)0.696(0.770)-0.178(-0.189)0.207(0.325)0.714(1.414)0.194(0.293)0.543(1.956)-2.427(-1.337)0.355(0.200) ρ1ρ1ρ1ρ (-0.213)0.002(0.011)-0.472(-3.558)-0.397(-3.718)-0.720(-2.727)-0.799(-3.168)-0.341(-4.127)-0.377(-4.532)-0.506(-4.127)-0.760(-3.946) ρ2ρ2ρ2ρ (2.260)-0.454(-1.739)-0.123(-0.786)0.030(0.187)-0.304(-1.001)-0.131(-0.486)-0.217(-1.658)-0.639(-2.211)-0.402(-1.180)-0.274(-1.452) Wp-value R1p-value R2p-value Lag

M-TAR model (cont.) CountryFRAUSFRAGERITAUSITAGERSPAUSSPAGERUKUSUKGERUSGER λ m μ1μ1μ1μ10.627(2.381)0.004(0.020)0.026(0.153)-0.453(-1.416)0.100(0.615)0.044(0.264))-0.025(-0.191)-0.818(-0.917)0.510(2.433) μ2μ2μ2μ (-1.659)0.177(1.482)-0.048(-0.279)0.290(1.455)-0.448(-3.029)-0.230(-1.145)-0.441(-0.964)0.328(2.774)0.019(0.262) ρ1ρ1ρ1ρ (-1.198)-0.566(-2.699)-0.124(-0.945)-0.005(-0.031)-0.126(-0.834)-0.092(-0.688))-0.388(-1.482)-0.313(-0.444)-0.379(-1.798) ρ2ρ2ρ2ρ (-1.757)-0.472(-2.139)-0.041(-0.273)-0.204(-1.502)0.074(0.515)-0.044(-0.242)-0.795(-2.202)-0.903(-3.235)-0.549(-3.671) Wp-value R1p-value R2p-value Lag

Equilibrium is statistically different from zero in most countries. -Permanent rids -The long run mean of developing economies is higher than developed countries. Conclusions Next Chapters: What are the Causes? Evidence Supporting RIPH Evidence Against RIPH Rids tend to be short lived if structural breaks are taken into account. - Foreign financial crises seem to have impacted rids of emerging markets.