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The paper was written while the author was a visiting consultant at the Research Department of the International Monetary Fund. Correspondence: Kate Phylaktis, Department of Banking, City University Business School, Frobisher Crescent, Barbican Centre, London EC2Y 8HB. Fax:071-4778881
The change in the exchange rate is assumed to be zero.
The results are robust with respect to countries, interest rates and price deflators.
It should be noted that if we have a higher order auto regressive process, equation (5) is modified to
and the long-term equilibrium real interest rate differential is
after taking the unconditional expectation of the process in (5a) and assuming that |Σci|<1.
In the case of higher order autoregressive process shocks to the system are corrected at the rate of
The ADF test for unit roots involve estimating the following regression using ordinary least squares:
where xt is the individual time series, D is the first difference operator (i.e. Dxt = xt - xt-1), ϵt is a serially uncorrelated random term, and a is a constant. The terms Dxt-j, j=1, 2,....N, are included to ensure that εt is white noise. Rejection of a unit root, which implies that the series is stationary, requires the coefficient on xt-1, (1-γ) to be negative and significant. The ADF test (or the DF test when it is not necessary to add any lagged differences in order to induce whiteness in the residuals) is based on the conventionally computed t-statistic (Fuller 1976; Dickey and Fuller 1981). The distribution for this statistic is non-standard and depends on the presence of an intercept in the equation. Critical values are reported in Fuller (1976) and Dickey and Fuller (1981).
The likelihood ratio test for the existence of at most r cointegrating factors or at least (p-r) unit roots in a set of ρ variables is:
The ŵis are the squared canonical correlations (ŵ1>ŵ2>.....> ŵp) between the two sets of residual vectors, R0t and R1t, obtained in the following two regressions:
where Xt is the p-vector of variables and Гji are matrices of coefficient estimates. Cointegration holds if r is greater than or equal to 1. Johansen (1988) shows that -21nQr is distributed as a function of a (p-r) dimensional standard Brownian motion and tabulates the distribution of the test statistic. In the case where p=l this test reduces to a unit root test for a single series.
Gensaki transactions consist of the resale or repurchase of bonds at a fixed price after a fixed period. They are short-term capital transactions using bonds as collateral. Prior to 1977.02 we have used the 60-day Gensaki rate.
The size of these markets remains substantial, but has fallen over the years. For example, in the mid 1970s the aggregate size of the curb market in Taiwan was as large as that of all financial institutions put together. In 1986, according to flow of funds accounts for private business enterprises, the ratio of curb market to total bank borrowing was 48 percent in 1986 (see Fry, 1990).
Data on prices refer to consumer price index and were taken from the International Financial Statistics published by he International Monetary Fund, except for Taiwan where prices were taken form Monthly Statistics of the Republic of China. Data on interest rates for Malaysia, Hong Kong and Singapore were provided by Nomura Bank; for Korea by the International Monetary Fund; for Taiwan were taken from the Financial Statistics Monthly, Taiwan District, Republic of China; and for U.S. and Japan from Datastream.
It should be noted that U.S. had no foreign exchange controls during the whole sample period, so that the current exercise on the degree of capital market integration reflects developments in the Pacific Basin countries.
All returns and inflation rates are continuously compounded.
The Augmented Dickey Fuller regressions were also estimated using a trend term. The order of integration for each of the series remained the same. Thus, the possibility of trend stationarity is rejected.
The particular specification included the U.S. real interest rate on the right hand side regressor. Lags were added to ensure whiteness of the standard error and the Schwarz’s (1978) Bayesian criterion was used to select the appropriate lag structure.
Estimates of the cointegrated parameters were smaller than one and had small standard errors. As it has been noted, nonstationarity of the real rates precludes using the parameters and standard errors for formal hypothesis testing.
Once again lags were added to ensure whiteness of the standard error and the Schwarz’s (1978) Bayesian criterion was used to select the appropriate lag structure.
Similar results were obtained when using the Johansen test statistic.
By dividing the sample period into pre- and post-liberalization sub-periods we take care of the possible changes in the long-run equilibrium real interest rate differential.