4 - Interest parity conditions as indicators of international financial integration

Summary

The integration of markets implies, on the face of it, an increase in transactions and a tendency for prices in those markets to converge. Hence, the international integration of financial markets implies an increase in capital flows and a greater tendency for the common-currency prices and returns on traded financial assets in different countries to converge. The convergence of returns is typically measured by closed, covered, uncovered and real interest parity over a set of traded assets including money market instruments, long-term securities and equity. This chapter examines covered, uncovered and real interest parity for money market instruments in Australia, Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand to evaluate the financial integration of these economies with the world market.

In the first section, some issues concerning data are then discussed. New evidence is presented and assessed on covered interest parity relative to US traded assets for Australia, Hong Kong, Japan, Malaysia, Singapore, Taiwan and Thailand. Particular attention is paid to whether the 1990s are different from the 1980s (and if so, why) and the importance of periodic rather than systematic exchange controls is highlighted. Mean uncovered interest differentials are then estimated and standard tests of uncovered interest parity applied, yielding a striking difference in the results between financially open and closed economies. McCallum's (1994) model is used to explain this and the inference is drawn that tests of uncovered interest parity may in fact contain considerable information about financial openness.