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

months. Gourinchas and Tornell (2004) and Bacchetta and van Wincoop (2006) relate delayed overshooting
as a potential reason for deviations from the UIP condition to departures from rational expectations.

⁷See Mody (2004) for a discussion on which market economies can be labeled as “emerging”.

⁸ Among others, Edwards (2007) and Kose et al. (2006) provide indices for the degree of capital mobility
for both the developed and emerging market economies, elaborating that although emerging markets have
achieved a significant degree of capital market integration in the recent years, it is still less than that for the
developed economies. See Kose et al. (2006) for an additional discussion on measuring de jure and de facto
degree of capital market integration.

⁹Employing a different methodology, Tanner (1998) analyzes sample properties of ex post deviations from
the UIP condition, and report that the deviations are stationary with a close-to-zero mean for both emerging
and developed markets. Note that by analyzing deviations from the real interest parity condition, Ferreira
and Leon-Ledesma (2007) do not corroborate these less unfavorable findings for the UIP condition for
emerging markets. In particular, Ferreira and Leon-Ledesma report stationary real interest rate differential
albeit around a positive mean for emerging markets, as opposed to stationary around a zero mean real
interest differentials for developed economies. The results of Ferreira and Leon-Ledesma imply that ex ante
PPP and/or UIP does not hold for emerging markets, yet it is hard to extract which one exists or dominates.

¹⁰This point is further confirmed by Bacchetta and van Wincoop (2006) who demonstrate that persistent
inflation shocks induce an exchange rate depreciation together with an increase in interest differential. In
addition, Alvarez et al. (2006) show that the volatility of the risk premia is lower for economies experiencing
high and chronic inflation rates, which implies that the UIP slope estimates are expected to be closer to one
for these economies.

¹¹For a further discussion on the choice of base currency, see Lee (2006).

¹²Testing for other interest parity conditions, i.e. covered and real interest parities, may have implications
for interpreting empirical evidence on the UIP condition. Hence, on occasion, we also refer to these.

¹³ Note, also, that structural changes, particularly financial liberalizations do not occur at a specific date,
and hence should be represented as gradual processes.

¹⁴Some empirical studies on other parity conditions take into account regime switch dates. Mansori (2003)
tests for the CIP condition before and after the de jure break date. Baharumshah et al. (2005) analyze
the effect of liberalization on real interest differentials for ten Asian emerging markets vis -a´-vis Japan and
use a common ad hoc break date for the whole sample. They report that real interest parity holds for the
post-liberalization era.

¹⁵ Using endogenously determined structural breaks, Singh and Banerjee (2006) and Ferreira and Leon-
Ledesma (2007) analyze the stationarity of deviations from the real interest parity condition for a set of
emerging markets. Both studies report stationary real interest differentials when structural breaks are taken

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