The Dynamics and Causes of Real Interest The Dynamics and Causes of Real Interest Rate Differentials: An Investigation for Rate Differentials: An Investigation for

Developed and Emerging MarketsDeveloped and Emerging Markets

PhD ProjectAlex Luiz Ferreira

Supervisors:

Dr. Miguel A. León-Ledesma & Prof. Roger Vickerman

Department of Economics, University of Kent, UK

ThesisThesis

Is there any evidence of real Is there any evidence of real interest rate differentials in a set of interest rate differentials in a set of

emerging and developed emerging and developed economies?economies?

Yes

What are the underlying causes of the differentials?

Motivation and RelevanceMotivation 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 ThesisStructure of the Thesis

– Chapter 1.Chapter 1. Real Interest Rate Parity: Theory and Evidence Real Interest Rate Parity: Theory and Evidence Literature ReviewLiterature Review

– Chapter 2.Chapter 2. Does the Real Interest Rate Parity Hold? Evidence Does the Real Interest Rate Parity Hold? Evidence for Developed and Emerging Marketsfor Developed and Emerging Markets

First Research QuestionFirst Research Question

– Chapter 3.Chapter 3. The Dynamics of Interest Rate Differentials The Dynamics of Interest Rate Differentials Blanchard and Quah (1989) variance decompositionBlanchard and Quah (1989) variance decomposition

– Chapter 4.Chapter 4. Breaking Down UIRP: Risk and Uncertainty Breaking Down UIRP: Risk and Uncertainty

– Chapter 5.Chapter 5. Investigating the Causes of Default Risk and Investigating the Causes of Default Risk and Exchange Rate UncertaintyExchange Rate Uncertainty

PaperPaper

Does the Real Interest Parity Does the Real Interest Parity Hypothesis Hold? Evidence for Hypothesis Hold? Evidence for

Developed and Emerging Developed and Emerging MarketsMarkets

Department of Economics, University of Kent, UK

Alex Luiz FerreiraMiguel Leon-Ledesma

Working Paper 0301

Is there evidence of real interest rate Is there evidence of real interest rate equalisation in a sample of equalisation in a sample of

developed and emerging markets in developed and emerging markets in the recent period of liberalised trade the recent period of liberalised trade

and capital flows?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 ContributionMotivation and Contribution

– Mixed evidence and Default PossibilityMixed evidence and Default Possibility– Market IntegrationMarket Integration

focus on focus on postpost liberalisation period (from 1995:3 to 2002:5) liberalisation period (from 1995:3 to 2002:5) inclusion of emerging markets: inclusion of emerging markets: Argentina, Brazil, Chile, Mexico Argentina, Brazil, Chile, Mexico

and Turkeyand Turkey Countries supposed to be well integrated: Countries supposed to be well integrated: France, Italy, Spain France, Italy, Spain

and UK; Germany and USA as reference countriesand UK; Germany and USA as reference countries

– TechniquesTechniques Few Unit Root TestsFew Unit Root Tests:: Meese and Rogoff (1988), Edison and Pauls Meese and Rogoff (1988), Edison and Pauls

(1993) and Obstfeld and Taylor (2002); Advantage over Cointegration.(1993) and Obstfeld and Taylor (2002); Advantage over Cointegration.

More Powerful TechniquesMore Powerful Techniques – KPSS (1992), ERS (1996), Elliot (1999) KPSS (1992), ERS (1996), Elliot (1999) – Structural Breaks - Perron (1997)Structural Breaks - Perron (1997)

Asymmetries are Taken into AccountAsymmetries are Taken into Account– M-Tar ModelM-Tar Model

Real Interest Rate Parity Hypothesis (RIPH)Real Interest Rate Parity Hypothesis (RIPH)

0 1 12

p

t t i t i ti

rid a rid rid

0

0

00 and 0a

00 and 0a

01 0

1

( ) 0 1 and 01t

aE rid a a

a

• Explosive

• Unit Root

• Persistent or Short-Lived

• Permanent

• RIPH

• General Stochastic Process

1

1q

ii

a

ridsridsArgentina

1995 1996 1997 1998 1999 2000 2001-1

0

1

2

3

4

5

6

7Ger

US

Brazil

1995 1996 1997 1998 1999 2000 20010.0

2.5

5.0

7.5

10.0

12.5

15.0GerUS

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

Chile

1995 1996 1997 1998 1999 2000 2001-1.6

-0.8

0.0

0.8

1.6

2.4

3.2

4.0

4.8USGer

Mexico

1995 1996 1997 1998 1999 2000 2001-1.8

-0.9

0.0

0.9

1.8

2.7

3.6

4.5

5.4USGer

ridsrids

Spain

1995 1996 1997 1998 1999 2000 2001-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0USGer

Italy

1995 1996 1997 1998 1999 2000 2001-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0USGer

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

France

1995 1996 1997 1998 1999 2000 2001-1.0

-0.5

0.0

0.5

1.0

1.5

2.0USGer

UK

1995 1996 1997 1998 1999 2000 2001-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0USGer

ridsrids

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

Turkey

1995 1996 1997 1998 1999 2000 2001-5

0

5

10

15

20

25USGer

US and Germany

1995 1996 1997 1998 1999 2000 2001-1.6

-1.2

-0.8

-0.4

-0.0

0.4

0.8

1.2

1.6GerUS

  Unit Root TestsUnit Root Tests   ADFADF KPSSKPSS ERSERS Elliot (1999)Elliot (1999)

Country - ReferenceCountry - Reference lagslags t-ratiot-ratio DF-GLSDF-GLS DF-GLSDF-GLSuu

Argentina – USArgentina – US 1010 -0.421-0.421 0.389*0.389* -0.855-0.855 -0.878-0.878

Argentina – GerArgentina – Ger 1010 0.4180.418 0.411*0.411* -0.738-0.738 -0.554-0.554

Brazil – USABrazil – USA 33 -3.015*-3.015* 0.7020.702 -2.489*-2.489* -2.937*-2.937*

Brazil – GerBrazil – Ger 33 -3.119*-3.119* 0.7510.751 -2.852*-2.852* -3.077*-3.077*

Chile – USChile – US 1212 -2.054-2.054 0.179*0.179* -1.971*-1.971* -2.086-2.086

Chile – GerChile – Ger 66 -2.024-2.024 0.260*0.260* -1.587-1.587 -2.041-2.041

Mexico – USMexico – US 11 -4.593*-4.593* 0.239*0.239* -2.901*-2.901* -4.580*-4.580*

Mexico – GerMexico – Ger 11 -4.890*-4.890* 0.222*0.222* -2.690*-2.690* -4.821*-4.821*

Turkey – USTurkey – US 33 -4.230*-4.230* 0.078*0.078* -3.948*-3.948* -4.201*-4.201*

Turkey – GerTurkey – Ger 77 -3.827*-3.827* 0.067*0.067* -3.734*-3.734* -3.849*-3.849*

France – USFrance – US 1010 -2.259-2.259 0.186*0.186* -0.424-0.424 -1.783-1.783

France – GerFrance – Ger 99 -2.490-2.490 0.199*0.199* -0.845-0.845 -1.785-1.785

Italy – USItaly – US 99 -1.485-1.485 0.6880.688 -0.945-0.945 -1.312-1.312

Italy – GerItaly – Ger 99 -0.993-0.993 0.6530.653 -1.357-1.357 -1.065-1.065

Spain – USSpain – US 99 -1.759-1.759 0.6430.643 -0.349-0.349 -1.144-1.144

Spain – GerSpain – Ger 1212 -1.533-1.533 0.5270.527 -0.990-0.990 -1.233-1.233

UK – USUK – US 1010 -1.723-1.723 0.153*0.153* -0.434-0.434 -1.624-1.624

UK – GerUK – Ger 1212 -3.203*-3.203* 0.222*0.222* -0.199-0.199 -2.796*-2.796*

(US) (Ger)(US) (Ger) 77 -2.752-2.752 0.082*0.082* -0.795-0.795 -1.803-1.803

Country – ReferenceCountry – Reference LagsLags Break DateBreak Date T-ratioT-ratio

Argentina – USArgentina – US 99 2001:072001:07 -1.529-1.529

Argentina – GerArgentina – Ger 99 2001:072001:07 -1.238-1.238

Brazil – USBrazil – US 00 1995:091995:09 -5.184*-5.184*

Brazil – GerBrazil – Ger 00 1995:081995:08 -5.224*-5.224*

Chile – USChile – US 00 1998:101998:10 -5.726*-5.726*

Chile – GerChile – Ger 22 1997:101997:10 -4.837*-4.837*

Mexico – USMexico – US 11 1998:091998:09 -4.613*-4.613*

Mexico – GerMexico – Ger 11 1998:091998:09 -4.901*-4.901*

Turkey – USTurkey – US 33 1999:071999:07 -4.299*-4.299*

Turkey – GerTurkey – Ger 11 1999:071999:07 -4.984*-4.984*

France – USFrance – US 1010 1996:101996:10 -2.637-2.637

France – GerFrance – Ger 1010 2000:112000:11 -2.780-2.780

Italy – USItaly – US 1111 1996:111996:11 -4.128*-4.128*

Italy – GerItaly – Ger 99 1997:111997:11 -4.729*-4.729*

Spain – USSpain – US 99 1997:051997:05 -3.375-3.375

Spain – GerSpain – Ger 99 1997:061997:06 -4.843*-4.843*

UK – USUK – US 99 1998:031998:03 -2.871-2.871

UK – GerUK – Ger 1212 2001:092001:09 -3.824*-3.824*

(US) (Ger)(US) (Ger) 77 1996:101996:10 -3.114-3.114

10 1 1( )

p

i t i ti

t t b t t ridrid a DU D T a rid

Structural Break - Perron (1997)

  Half Lives (months)Half Lives (months)Country – Country – ReferenceReference ADFADF

Structural Structural BreakBreak

Argentina – USArgentina – US 13.113.1 3.23.2

Argentina – GerArgentina – Ger ---- 3.13.1

Brazil – USABrazil – USA 3.03.0 1.21.2

Brazil – GerBrazil – Ger 2.72.7 1.21.2

Chile – USChile – US 1.11.1 0.90.9

Chile – GerChile – Ger 1.41.4 0.60.6

Mexico – USMexico – US 1.61.6 1.61.6

Mexico – GerMexico – Ger 1.51.5 1.41.4

Turkey – USTurkey – US 1.01.0 0.90.9

Turkey – GerTurkey – Ger 0.60.6 1.01.0

France – USFrance – US 1.31.3 0.80.8

France – GerFrance – Ger 1.01.0 0.60.6

Italy – USItaly – US 7.37.3 1.51.5

Italy – GerItaly – Ger 10.310.3 0.40.4

Spain – USSpain – US 5.05.0 0.80.8

Spain – GerSpain – Ger 5.65.6 1.01.0

UK – USUK – US 1.81.8 1.11.1

UK – GerUK – Ger 0.30.3 0.20.2

(US) (Ger)(US) (Ger) 1.31.3 1.01.0

ln(2)Half-life=

ln(1 )

  Equilibrium Equilibrium LevelsLevels

ADFADF Structural BreakStructural Break

Country – ReferenceCountry – ReferencePeriod 1Period 1

Period 2Period 2

Argentina – USArgentina – US 2.332.33 1.48*1.48* 10.4210.42

Argentina – GerArgentina – Ger 0.820.82 1.67*1.67* 9.99.9

Brazil – USABrazil – USA 3.82*3.82* 11.10*11.10* 3.92*3.92*

Brazil – GerBrazil – Ger 3.87*3.87* 11.54*11.54* 4.12*4.12*

Chile – USChile – US 0.98**0.98** 1.05*1.05* 0.740.74

Chile – GerChile – Ger 1.12**1.12** 1.37*1.37* 1.131.13

Mexico – USMexico – US 1.37*1.37* 1.12*1.12* 1.641.64

Mexico – GerMexico – Ger 1.25*1.25* 1.35*1.35* 1.731.73

Turkey – USTurkey – US 4.44*4.44* 4.70*4.70* 4.224.22

Turkey – GerTurkey – Ger 4.95*4.95* 5.09*5.09* 4.194.19

France – USFrance – US -0.05-0.05 0.20.2 -0.08-0.08

France – GerFrance – Ger 0.10.1 0.080.08 0.250.25

Italy – USItaly – US -0.11-0.11 0.79*0.79* -0.17*-0.17*

Italy – GerItaly – Ger -0.31-0.31 1.031.03 -0.08-0.08

Spain – USSpain – US -0.31-0.31 0.53*0.53* -0.34*-0.34*

Spain – GerSpain – Ger -0.17-0.17 0.68*0.68* -0.26*-0.26*

UK – USUK – US 0.220.22 0.070.07 0.340.34

UK – GerUK – Ger 0.35*0.35* 0.340.34 0.680.68

(US) (Ger)(US) (Ger) 0.15**0.15** 00 0.190.19

0

11

a

a

M-TAR modelM-TAR model

CountryCountry ARGUSARGUS ARGERARGER BRAUSBRAUS BRAGERBRAGER CHIUSCHIUS CHGERCHGER MEXUSMEXUS MEXGERMEXGER TURUSTURUS TURGERTURGER

λλ -0.381-0.381 0.2470.247 -0.459-0.459 -0.420-0.420 -0.237-0.237 -0.502-0.502 -0.886-0.886 -0.872-0.872 -0.926-0.926 1.2901.290

mm 22 55 22 22 11 33 11 11 11 22

μμ11 -0.013-0.013(-0.055)(-0.055)

-0.177-0.177(-0.524)(-0.524)

1.6791.679(1.829)(1.829)

2.4682.468(2.572)(2.572)

1.4281.428(2.610)(2.610)

1.3581.358(2.389)(2.389)

0.6870.687(2.421)(2.421)

0.6430.643(2.237)(2.237)

3.0273.027(2.997)(2.997)

5.9565.956(3.196)(3.196)

μμ22 -0.584-0.584(-1.867)(-1.867)

-0.187-0.187(-0.515)(-0.515)

0.6960.696(0.770)(0.770)

-0.178-0.178(-0.189)(-0.189)

0.2070.207(0.325)(0.325)

0.7140.714(1.414)(1.414)

0.1940.194(0.293)(0.293)

0.5430.543(1.956)(1.956)

-2.427-2.427(-1.337)(-1.337)

0.3550.355(0.200)(0.200)

ρρ11 -0.031-0.031(-0.213)(-0.213)

0.0020.002(0.011)(0.011)

-0.472-0.472(-3.558)(-3.558)

-0.397-0.397(-3.718)(-3.718)

-0.720-0.720(-2.727)(-2.727)

-0.799-0.799(-3.168)(-3.168)

-0.341-0.341(-4.127)(-4.127)

-0.377-0.377(-4.532)(-4.532)

-0.506-0.506(-4.127)(-4.127)

-0.760-0.760(-3.946)(-3.946)

ρρ22 -0.355-0.355(2.260)(2.260)

-0.454-0.454(-1.739)(-1.739)

-0.123-0.123(-0.786)(-0.786)

0.0300.030(0.187)(0.187)

-0.304-0.304(-1.001)(-1.001)

-0.131-0.131(-0.486)(-0.486)

-0.217-0.217(-1.658)(-1.658)

-0.639-0.639(-2.211)(-2.211)

-0.402-0.402(-1.180)(-1.180)

-0.274-0.274(-1.452)(-1.452)

WWp-valuep-value

17.6417.640.0400.040

6.1286.1280.3430.343

0.8650.8650.9030.903

9.4179.4170.0230.023

5.3675.3670.4400.440

8.2108.2100.0100.010

1.561.560.7070.707

2.432.430.4870.487

21.47021.4700.0000.000

27.91227.9120.0000.000

R1R1p-valuep-value

2.9542.9540.2270.227

0.5320.5320.5870.587

9.1129.1120.0100.010

10.25610.2560.0030.003

8.6958.6950.0500.050

8.1378.1370.0230.023

22.60322.6030.0000.000

26.15426.1540.0000.000

21.1621.160.0000.000

15.86615.8660.0060.006

R2R2p-valuep-value

4.0174.0170.3600.360

1.2341.2340.7330.733

9.1399.1390.0470.047

13.85913.8590.0000.000

8.4378.4370.1330.133

7.6757.6750.0870.087

19.78319.7830.0000.000

25.42525.4250.0000.000

20.57520.5750.0030.003

15.96015.9600.0370.037

LagLag 1010 1010 33 33 1212 66 11 11 33 77

1 1

' '1 1 2 1

1

1 1t t

p

t t t j t j tz zj

y y y rid

M-TAR model (cont.)M-TAR model (cont.)

CountryCountry FRAUSFRAUS FRAGERFRAGER ITAUSITAUS ITAGERITAGER SPAUSSPAUS SPAGERSPAGER UKUSUKUS UKGERUKGER USGERUSGER

λλ 0.2640.264 0.3990.399 -0.087-0.087 0.3470.347 0.0300.030 -0.220-0.220 -1.110-1.110 0.8010.801 0.5060.506

mm 66 55 44 55 22 66 33 11 11

μμ11 0.6270.627(2.381)(2.381)

0.0040.004(0.020)(0.020)

0.0260.026(0.153)(0.153)

-0.453-0.453(-1.416)(-1.416)

0.1000.100(0.615)(0.615)

0.0440.044(0.264))(0.264))

-0.025-0.025(-0.191)(-0.191)

-0.818-0.818(-0.917)(-0.917)

0.5100.510(2.433)(2.433)

μμ22 -0.221-0.221(-1.659)(-1.659)

0.1770.177(1.482)(1.482)

-0.048-0.048(-0.279)(-0.279)

0.2900.290(1.455)(1.455)

-0.448-0.448(-3.029)(-3.029)

-0.230-0.230(-1.145)(-1.145)

-0.441-0.441(-0.964)(-0.964)

0.3280.328(2.774)(2.774)

0.0190.019(0.262)(0.262)

ρρ11 -0.278-0.278(-1.198)(-1.198)

-0.566-0.566(-2.699)(-2.699)

-0.124-0.124(-0.945)(-0.945)

-0.005-0.005(-0.031)(-0.031)

-0.126-0.126(-0.834)(-0.834)

-0.092-0.092(-0.688))(-0.688))

-0.388-0.388(-1.482)(-1.482)

-0.313-0.313(-0.444)(-0.444)

-0.379-0.379(-1.798)(-1.798)

ρρ22 -0.382-0.382(-1.757)(-1.757)

-0.472-0.472(-2.139)(-2.139)

-0.041-0.041(-0.273)(-0.273)

-0.204-0.204(-1.502)(-1.502)

0.0740.074(0.515)(0.515)

-0.044-0.044(-0.242)(-0.242)

-0.795-0.795(-2.202)(-2.202)

-0.903-0.903(-3.235)(-3.235)

-0.549-0.549(-3.671)(-3.671)

WWp-valuep-value

5.9415.9410.3570.357

16.98416.9840.0400.040

15.67915.6790.0160.016

8.6318.6310.1830.183

13.50413.5040.0570.057

4.7744.7740.4330.433

0.7270.7270.9470.947

5.5975.5970.4370.437

20.42020.4200.0060.006

R1R1p-valuep-value

7.7107.7100.0600.060

7.9777.9770.0430.043

0.8230.8230.5230.523

0.8230.8230.4160.416

0.1350.1350.7830.783

1.081.080.4230.423

5.4325.4320.0900.090

16.75416.7540.0000.000

10.10510.1050.0100.010

R2R2p-valuep-value

7.1057.1050.1770.177

3.8713.8710.3530.353

0.9680.9680.7900.790

1.8921.8920.5830.583

0.8040.8040.7730.773

0.7340.7340.8460.846

6.0276.0270.2170.217

10.78210.7820.0930.093

16.09816.0980.0100.010

LagLag 1010 1010 99 99 99 1212 1111 1212 77

• Equilibrium is statistically different from zero in most countries.

- Permanent rids - The long run mean of

developing economies is higher than developed countries.

ConclusionsConclusions

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.