Exchange Rate and Interest Rate Disconnect: The Role of Capital Flows, Currency Risk and Default Risk

Using survey based measures of exchange rate expectations from a large set of advanced countries and emerging markets during 1996–2015, we document new facts on international arbitrage and exchange rate determination. We find that positive interest rate differentials imply expected depreciation as predicted by the no-arbitrage condition, however the expected depreciation is not enough to offset the interest rate differentials, leading to UIP deviations. To understand why there is not a full offset, we evaluate the response of each component of the UIP relation—that is the interest rate differential term and and exchange rate adjustment term—to changes in global risk and country fundamentals. This exercise reveals that, in short horizons (1-3 month), expected depreciation as a response to a given shock is large enough to offset most of the interest rate differentials, narrowing down the UIP deviations in general, and vanishing them in the advanced economies. In long horizons (12 month), this is not the case due to a combination of different factors in different countries. In advance countries, currency risk plays a key role, where in bad times (high global risk), currency depreciates more than the expectations, leading to larger deviations. In emerging markets, there is not enough movement in the exchange rate adjustment term. Capital outflows from emerging markets as a result of both higher global risk and worsening country fundamentals lead to larger interest rate differentials. Although there is an expected and actual depreciation as a result of such outflows, these are not enough to offset the interest rate differentials as the role played by the default risk is more important.