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Indian Capital Control Liberalization: Evidence from NDF Markets

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Author Info
Hutchison, Michael
Kendall, Jake
Pasricha, Gurnain Kaur
Singh , Nirvikar

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Abstract

The Indian government has taken a number of incremental measures to liberalize legal and administrative impediments to international capital movements in recent years. This paper analyzes the extent to which the effectiveness of capital controls in India, measured by the domestic less net foreign interest rate differential (deviations from covered interest rate parity) have changed over time. We utilize the 3-month offshore non-deliverable forward (NDF) market to measure the effective foreign interest rate (implied NDF yield). Using the self exciting threshold autoregression (SETAR) methodology, we estimate a no-arbitrage band width whose boundaries are determined by transactions costs and capital controls. Inside of the bands, small deviations from CIP follow a random walk process. Outside the bands, profitable arbitrage opportunities exist and we estimate an adjustment process back towards the boundaries. We allow for asymmetric boundaries and asymmetric speeds of adjustment (above and below the band thresholds), which may vary depending on how arbitrage activity is constrained by capital controls. We test for structural breaks, identify three distinct periods, and estimate these parameters over each sub-sample in order to capture the de facto effect of changes in capital controls over time. We find that de facto capital control barriers: (1) are asymmetric over inflows and outflows, (2) have changed over time from primarily restricting outflows to effectively restricting inflows (measured by band widths and positions); (3) arbitrage activity closes deviations from CIP when the threshold boundaries are exceeded in all sub-samples. In recent years, capital controls have been more symmetric over capital inflows and outflows and the deviations from CIP outside the boundaries are closed more quickly.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 13630.

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Date of creation: 17 Jan 2009
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Handle: RePEc:pra:mprapa:13630

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Related research
Keywords: capital controls; non-deliverable forward markets; India; economic reform; liberalization;

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Find related papers by JEL classification:
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
F31 - International Economics - - International Finance - - - Foreign Exchange
F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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  1. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-38, April. [Downloadable!] (restricted)
  2. Yin-wong Cheung & Dickson Tam & Matthew S. Yiu, 2006. "Does the Chinese Interest Rate Follow the US Interest Rate?," Working Papers 192006, Hong Kong Institute for Monetary Research. [Downloadable!]
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  3. Levy Yeyati, Eduardo & Schmukler, Sergio L. & Van Horen, Neeltje, 2006. "International financial integration through the law of one price," Policy Research Working Paper Series 3897, The World Bank. [Downloadable!]
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  4. Pasricha, Gurnain, 2008. "Financial integration in emerging market economies," MPRA Paper 2257, University Library of Munich, Germany, revised 10 Apr 2008. [Downloadable!]
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  5. Jushan Bai & Pierre Perron, 2003. "Computation and analysis of multiple structural change models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 18(1), pages 1-22. [Downloadable!]
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  6. Taylor, Mark P, 1989. "Covered Interest Arbitrage and Market Turbulence," Economic Journal, Royal Economic Society, vol. 99(396), pages 376-91, June. [Downloadable!] (restricted)
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