Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect
IMF Working Papers, February 10, 2023
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- Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect
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Bibliographic details
- Authors: Eugenio M Cerutti, Haonan Zhou
- Published: February 10, 2023
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400237003.001
Summary findings
- EM short-term Covered Interest Parity (CIP) deviations exhibit much larger volatilities than most G10 currencies.
- EM CIP deviations move in an opposite direction during global risk-off episodes.
- Offshore EM CIP deviations are sensitive to changes in FX dealers’ risk-bearing capacities and global risk aversion.
- Onshore EM CIP deviations are largely unresponsive in segmented FX markets.
- For currencies with segmented FX markets, the sensitivity of offshore CIP deviations to global risk factors is stronger compared to currencies with integrated FX markets.
- After accounting for global factors, there is weak evidence that country default risk affects EM CIP deviations.
Determinants and mechanisms
- Global risk aversion: a key global factor influencing offshore EM CIP deviations.
- FX dealers’ risk-bearing capacity: changes in dealers’ capacity materially affect offshore CIP deviations.
- Market segmentation: onshore markets that are segmented show muted responses of CIP deviations to the global drivers that affect offshore markets.
Distinctions across market segments
- Offshore vs onshore:
- Offshore CIP deviations: responsive to global risk factors and dealers’ risk-bearing capacities.
- Onshore CIP deviations: largely unresponsive where FX markets are segmented.
- Segmented vs integrated FX markets:
- Currencies in segmented markets: offshore deviations show stronger sensitivity to global risk factors than currencies in integrated markets.
Evidence on country default risk
- Once global factors are controlled for, country default risk provides only weak explanatory power for EM CIP deviations.
Key takeaways for policymakers and market participants
- Monitoring global risk aversion and FX dealers’ risk-bearing capacity is crucial for understanding offshore EM CIP deviations.
- Market segmentation alters how onshore CIP deviations respond to global shocks; reforms toward greater integration could change these dynamics.
- Assessments of country default risk should account for dominant global drivers when evaluating their role in CIP deviations.
IMF Working Paper by Eugenio M Cerutti and Haonan Zhou, February 10, 2023.
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