The fundamental determinants of financial integration in the European Union



Table 1 - The decomposition of the onshore covered nominal interest rate differential

(1) Offshore covered nominal interest rate differential
,            . Euro . * Euro , -t + к          ч

Фа™ = ≈,,>÷s “ l<,ι.l - </>    “S, )

(2) Domestic onshore-offshore closed nominal interest rate differential

.            _ .               . Euro

ɪ Domestic t, t + к ɪ t, t + к

(3) Foreign offshore-onshore closed nominal interest rate differential
.           _ ∙ * Furo _ ∙ ’

ɪ Foreign 11, t + к * t, t + к

(4)=(1)+(2)+(3) Onshore covered nominal interest rate differential
Φ Φ
Domestic + $ foreign + Φ Euro

i,,,tt - √,.→ - (f,'t* -s,) =

[ "f,.÷l - l>,<÷tl + [≈<.<÷s-,>.<÷tl + [ ≈<,>÷s - >>,<÷t - (∕>   -S,)]

Now, we may derive our measure for the intensity of capital controls. The domestic intensity of capital controls may be
approximated by the adjusted domestic covered nominal interest rate differential

Domestic Φ Φ Foreign Φ Domestic + Φ Euro ɪ t, t + к 4 ,t tk (ʃɪ $ ï )

while the foreign intensity of capital controls may be approximated by the adjusted foreign covered nominal interest rate differential

Foreign Φ Φ Domestic Φ Foreign + Φ Euro t, t + к ɪ t, t + к (ʃɪ ® Г

where banks ensure that offshore covered nominal interest rate parity holds continuously. That is, we may write

. Euro        . » Euro      t rt + к         -.

>>,>÷t = ≈<,>÷s + <∕<   -s,)

and

. » Euro      . Euro        t rt + к         -.

>>,,÷t = ≈<,>÷S - <∕<   -s,)

Symbols:
'<,t÷t
. Euro
lt.t + k



domestic onshore nominal rate of interest at time t on a k-period bond held between time t and t+k
domestic offshore nominal rate of interest at time t on a k-period bond held between time t and t+k
forward exchange rate at time t for the delivery of foreign currency at time t+k

spot exchange rate at time t (defined as units of domestic currency per unit of foreign currency)
holding period of the underlying debt instrument

denotes a foreign variable

Source: Goldsbrough and Teja (1991) and authors’ own summary of the literature.

Consequently, the domestic intensity of capital controls may either be measured by the domestic onshore-
offshore closed nominal interest rate differential

Ф Domestic


.           _ . Euro

l t ,t + к ~ l t,t + к


(1)


or by the adjusted domestic covered nominal interest rate differential

_ .          _ . * Euro _ f rt + k _

(2)


Domestic t , t + к t , t + к J t         ^t

Capital controls will be an important reason for significant deviations from onshore covered nominal interest
parity.7 Since offshore covered nominal interest rate parity is zero by assumption, it follows that any
differential between the Euro-rate and the domestic rate on a comparable asset is likely to reflect domestic
capital controls. Closed and adjusted covered nominal interest rate differentials have been widely used to

7 More precisely, capital controls that are economically significant -- thus lying outside a small band of differentials created by
transaction costs.



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