CIP Deviations in Emerging Market Economies

Abstract

This paper examines the response of output and covered interest parity deviations to technology and financial shocks in emerging markets (EM). Following Fukuda and Tanaka (2017), we build a small open-economy model which allows us to highlight three possible theoretical scenarios. First, if much of the gains in domestic output emanate from favorable external technology shocks as opposed to domestic technology shocks, then deviations from covered interest parity will worsen and the basis will widen. When the basis widens, the implied cost of US dollars in the cross-currency swap market increases. Second, if gains in domestic output result from favorable technology shocks in the local economy, as opposed to foreign technology shocks, then the basis will tighten. When the basis tightens, the implied cost of US dollars in the cross- currency swap market reduces. Lastly, if domestic output gains emanate equally from domestic and foreign technology shocks, then the overall effect on the basis is muted. In the empirical part using structural VAR with long-run restrictions, we identify technology shocks as the only source of unit root in output while both technology and financial shocks affect the basis. With this, we document that the response of the basis to technology shocks is positive but sometimes is mixed, even for the same EM basis across maturities. For financial shocks, our results reveal that the response of the basis for each EM is more homogeneous and evolves negatively and is statistically significant across most maturities. We also show that technology shocks lead to gains in real output.