Asked • 05/24/19

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

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.

Lenny D.

By the way, the risk premium for and emerging market, k is going to be large


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