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The Development of Local Currency Bond Markets and Uncovered Interest Rate Parity

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  • Park, Cyn-Young

    (Asian Development Bank)

  • Shin, Kwanho

    (Department of Economics, Korea University)

Abstract

This paper investigates whether the uncovered interest parity (UIP) will hold more firmly if the local currency bond markets (LCBMs) are more developed, and the presence of nonbank financial institutions (NBFIs) is expanded. Deviations in UIP decrease as LCBMs develop, while the patterns of the UIP premium in emerging markets increasingly resemble patterns in advanced economies. Capital flows respond more sensitively to the UIP premium for emerging markets when LCBMs are more developed. These suggest the development of LCBMs and NBFIs might induce more active cross-border carry trades and reduce UIP deviations. However, greater carry trade positions may increase a country’s exposure to market disruptions and exchange rate volatility. Empirical results show that gross portfolio debt inflows increase (decrease) when the exchange rate appreciates (depreciates). While LCBMs becoming more developed can mitigate the negative effect of the original sin redux hypothesis in advanced economies, this aggravates the impact of exchange rate depreciation in emerging markets.

Suggested Citation

  • Park, Cyn-Young & Shin, Kwanho, 2023. "The Development of Local Currency Bond Markets and Uncovered Interest Rate Parity," ADB Economics Working Paper Series 677, Asian Development Bank.
    • Handle: RePEc:ris:adbewp:0677
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    References listed on IDEAS

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    Cited by:

    1. Jamel Boukhatem, 2024. "The effects of financial risk components on local-currency bond markets: theory and empirical evidence," SN Business & Economics, Springer, vol. 4(4), pages 1-19, April.

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    More about this item

    Keywords

    uncovered interest parity; local currency bond markets; emerging economies; nonbank financial institutions; capital inflows;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F62 - International Economics - - Economic Impacts of Globalization - - - Macroeconomic Impacts
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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