The Economics of Uncovered Interest Parity Condition for Emerging Markets: A Survey

4 Conclusion

Recent methodological advances challenge the earlier unfavorable empirical literature on
the UIP condition for developed economies. Indeed, it has been documented that these
unfavorable results are mostly due to constraining the estimation to a linear framework,
ignoring the possibility of high persistence in the data, and are not valid for long- and
extremely short-investment horizons.

Do emerging markets merit a special treatment while testing for the UIP condition?
To our understanding of the literature, the short answer to this question is yes. Emerging
markets have been by and large characterized by weaker macroeconomic fundamentals,
more volatile economic conditions, shallower financial markets, and incomplete institutional
reforms. These structural differences between the developed and the emerging markets have
implications for the empirical tests of the UIP condition. In particular, the assumptions
of negligible transaction costs, perfect substitutability of the underlying assets and the
existence of deep financial markets are likely to be violated for emerging markets. These,
in turn, imply non-negligible transaction costs as well as default and political risks for
the emerging market assets, on top of the exchange rate risk which may also be relevant
for developed economies. Accordingly, while testing for the UIP condition, if emerging
markets are analyzed with the same methodology as developed economies, one would expect
relatively unfavorable results for the emerging markets.

It is remarkable, however, that the empirical studies that analyze both the developed and
the emerging market economies using conventional methodology document less unfavorable
results for the emerging market economies. These comparative studies, in general, argue
that this finding can be attributable to high inflation rates and easy-to-follow pattern of
macroeconomic fundamentals in these economies.

The aforementioned distinctive characteristics of emerging markets, having implications
for deviations from the UIP condition, shape how we classify the related literature that
specifically focus on emerging markets. Namely, first, recurrent financial turmoils and on-

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