Consequences of a positive uncovered interest rate parity (UIP) spread for an emerging market economy?

Question

Empirically we observe that the uncovered interest rate parity (UIP) does not hold; in fact the exchange rate adjusted return on an emerging market bond is higher than the return on US bonds; I know that the risk premium may account for this empirical observation and that a recent theoretical literature has emphasized the role of financially constrained international investors (Gabaix, and Maggiori, 2015). My question is: Does the receiving (emerging market) economy benefits from (or has an interest in maintaining) a positive UIP spread? Capital flows (especially short term capital flows, such as bond and portfolio flows) have been at the center-stage of a literature that emphasizes the negative effects (asset prices booms, sudden stops, conflict with the emerging market inflation targeting regime etc). To the extent that it is plausible to think that a positive UIP spread "encourages" these types of flows, why wouldn't the emerging market central bank try to compress the spread as much as possible? In theory the emerging market central bank of a very small economy could engage in foreign exchange interventions aimed at compressing the UIP spread, so to rephrase my question: what are the possible reasons that would instead justify maintaining (and maybe even contributing to maintain) a positive spread. What I can think of as of now: Consider a positive UIP spread: $ (1+i_t) - \\mathbb{E}_t\\Big[(1+i_t^*)\\frac{e_{t+1}}{e_{t}}\\Big] >0$, where $i_t^*$ is the US interest rate at time $t$, $i_t$ is the domestic interest rate in the emerging market economy at time $t$, $e_{t+1}$ is the exchange rate at time $t+1$ (expressed in terms of units of domestic currency per unit of foreign (dollar) currency) and $e_t$ is the exchange rate at time $t$. It is certainly possible for a central bank to use foreign exchange interventions (possibly) together with interest rate policy in order to achieve a zero UIP gap; for instance the central bank could increase the domestic interest rate or sell foreign exchange reserves with the objective of appreciating the period $t$ exchange rate, or a combination of the two. A higher domestic interest rate is however contractionary and an appreciated domestic currency (for a given domestic policy rate, $i_t$) would certainly reduce exports (which generally represent an important segment of emerging market economies). In relation to the latter point it is unclear to me whether this is however going to have a negative impact on domestic welfare -- households in the emerging market economy could be actually better off since their currency is now stronger, and they can therefore substitute part of their consumption basket with imported goods while at the same time reducing their (welfare reducing) labor supply to the domestic firms. This outcome can indeed arise when there is a terms of trade externality (see for example De Paoli, 2009).Any other ideas?Sources: De Paoli, Bianca. "Monetary policy and welfare in a small open economy." Journal of international Economics 77.1 (2009): 11-22.Gabaix, Xavier, and Matteo Maggiori. "International liquidity and exchange rate dynamics." The Quarterly Journal of Economics 130.3 (2015): 1369-1420.

Answer 1

You are thinking way too much and are getting caught up in all kinds of minutea. I spent a bit of time teaching this stuff at Tufts. Then I went to Wall Street and actually got to play in these markets for way too many years. Throwing around billions of dollars a day can get you to gray prematurely. Tests of UIP have failed miserably because those doing the testing have never sat on a trading desk. Suppose US 1 year paper is 2.5 percent and UK paper is 1.5% UIP would have us think that the pound will depreciate by 1% over the next year. Where is volatility in this equation? Suppose stg trades in a range of about 3/4th% a day or 12% per year. So the British investor who has located funds in the US at 2.5% can figure his returns will be 2% + or - 12% 68% of the time with a 32% change of more extreme deviations. So What do you want, 1.5% or a crap shoot. The fact is, Interest rate differentials are so much less volatile than currency movements that the statistical hypothesis testing is ludicrous. You really have to understand the Sandbox you are playing in.

I will lay ourt a simple framework I want you to think about.

Define PPP exchnge rate E* as

E*=P/P* Where E is the Home currency price of FX P* is the foreign Price level and P is the domestic Price level..Define a risk Factor RF= EXP(-k) In a long run equilibrium, PPP will hold up to a risk premium . Now define the exchange rate at any point in time as

E=(P/P*)*EXP(-k)EXP(u) where u is some random noise which has zero mean taking logs we have

ln(E)=e = p-p* -k +u note, E(e_t+k) = E(p_t+k)-E(p*_t+k) -E(k_t+k)

E( e') = E(p') -E(p*') - E(k'). (1)

as we are using logs, as such. the expected appreciation or depreciation will be explained by Changes in the expected inflation differential and change in the risk premium, k,

Now note that nominal interest rates i= r + Inflation risk premium the risk premium is a function of expected inflation and the variance (and possibly higher moments) of inflation

So in each country, Expected inflation = i - r - Inf Variance Premium If we substitute this in to equation 1 we see

E(e') = i - i* - (r-r*) -E(p')+E(p*') -(dom inf var prem - Foreign inf Var premium) - E (k') (2)

Looking to explain changes on simple Changes in interest rate differential is fool hardy. Nominal interest rate differentials can change because Real interest rate have changed. If the real interest rate differential changes such that the foreign real rate is higher than the domestic real rate we would expect the currency to appreciate. If the nominal interest rate is higher because expected inflation is higher or the variance of inflation is higher it will have just the opposite effect.

Due note that risk premium, k is probably corrected with real interest rates. The degree of correlation depends upon the degree of capital mobility.

The point is, Look at equation 2. When you are expecting all oft he events in the world being forecasted by interest rate differentials you are waliking a fraying tightrope.

I would welcome the opportunity to help guide you through this quagmire. A few years at Harvard and MIT got me thinking in this direction. Living in these markets and still breathing after 30 years is another whole story