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Hamid Faruqee is a Lecturer at the Woodrow Wilson School of Public and International Affairs, Princeton University. Work on this paper began as part of his summer intership in the Asian Department. The author would like to thank David Goldsbrough, Owen Evans, Ichiro Otani, Roger Kronenberg, and Ranjit Teja for helpful discussions and comments.
The methodology employed in this paper essentially follows that of Engle (1982), here applied to interest rate differentials for the Republic of Korea, Malaysia, Singapore, and Thailand.
The disposition between countries and interest rates is as follows: for Malaysia, the overnight interbank rate; for Korea, the daily rate on call money; and for Singapore and Thailand, three-month interbank rates.
Although the sample countries float vis-à-vis the yen, one can think of the Japanese offshore rate as a proxy for the rate of return and financial conditions in the “world” market. Given fixed exchange rates at some margin, a small open economy must import its inflation and money growth rates from abroad, fixing its risk-adjusted domestic interest rate in the long run. Using the U.S. LIBOR instead as the international rate of return does not change the findings presented here.
An uncovered version of interest rate parity with perfect capital mobility and asset substitulability can be written as
In the case of time-varying risk, this process is approximated with an exponential time trend, representing a smooth, downward convergence in the risk premium to its long-run value, paralleling a process of progressive financial liberalization and integration.
Final selections of appropriate time-series models, as reported in Table 1, were made through computing the SIC for numerous ARMA(p,q) specifications: (RSS + log(NOBS)*SEE2*K)/NOBS, where RSS = residual sum of squares, NOBS = number of observations, SEE = standard error of estimate, and K = number of repressors.
As the AR(1) coefficient goes to unity (unit root in A(L)), the model will exhibit nonstationarity or no mean reversion, and the effect of shocks becomes permanent. Although modeling Φ as an integrated process may not be rejected statistically as an alternative representation, theoretically this specification is very unappealing, for it suggests a perfectly closed capital account and no long-run equalization of risk-adjusted returns or significant nonstationarity in the risk premium inducing a sizable stochastic trend component in return differentials.
The ARCH test is conducted by regressing squared residuals on their lagged values and a constant. The particular order of the ARCH process (form of the ht function) is determined from the test regression found to be statistically significant. The ARCH test statistic is computed by NOBS*R2.
The ARCH statistic for Malaysia has a p-value of 0.170 (significance level). Also, MLE estimates for the first-order ARCH process suggest that Malaysian interest rate differentials are not covariance stationary (estimate on α > 1).
The findings for Korea are consistent with the results obtained by Reisen and Yèches (1991), who used a time-varying approach to financial openness following Edwards and Khan (1985), even though two different interest rates—a domestic curb market rate for Korea and the U.S. LIBOR—were used.
Changing capital mobility affects both the impulse and propagation of shocks to interest rate parity. Note that although time variation has been allowed for with respect to the former, the propagation mechanism has been kept constant over time (that is, same AR and MA coefficients) as an approximation. This approximation becomes less appropriate when capital mobility is near zero, suggesting that allowing for time variation in both dimensions—the amplitude and the persistence of interest rate parity deviations—may sharpen the results.
For Malaysia, the impulse-response functions were simulated using the initial ARMA estimates. Instead of using the nonstationary conditional variance function, an 18-month moving average of sample variances was calculated to determine the size of a typical one-standard-deviation shock.