In this paper we investigate the real interest parity condition in ten Eastern European transition countries during 1997-2009 period. Our sample is interesting for three reasons: It covers the second stage of economic transition in the aftermath of the collapse of socialism; the establishment of Euroland at the turn of the century: and enlargement of Euroland to include the Eastern European countries of Slovenia and Slovakia. The data enables us to investigate how the introduction of market mechanisms in the early nineties and the establishment and enlargement of Euroland acted on real interest rate convergence.
We test the real interest parity condition with unit root test with and without structural breaks. Inflationary expectations are estimated in two ways: (i) under assumption of rational expectations with ex-post inflation rates and (ii) with ex-ante estimated inflation expectation using ARIMA/ARCH model. Preliminary results suggest that there is a strong evidence of stationarity and relatively weaker evidence of structural breaks.
Tests of the interest rate parity in emerging economies usually result with puzzling outcome. According to the theoretical assumptions - perfect capital mobility, risk neutrality, and transaction costs - it is realistic to expect that interest rate parity will hold in developed economies, and that incomplete institutional reforms, relatively volatile economic conditions, weaker macroeconomic fundamentals and shallow financial markets will create major obstacles for the mean reversion of the interest rate differential in developing countries.
Contrary to theoretical implications, early empirical results have offered opposite evidence. Early studies for developed countries usually resulted in wrong signs of estimated coefficients (Sarno and Taylor 2002; Alper et al. 2007), while more recent estimates indicate non-linear mean reversion (Obstfeld and Taylor 2002; Nakagawa 2002). In the developing countries even linear methodology resulted with mean reverting estimates (Bansal and Dahlquist 2000; Flood and Rose 2002; Frankel and Poonawala 2006). When it comes to transition countries, environment for the estimation of interest rate parity is even more puzzling. Transition countries performed wide range of market based reforms during last 20 years, removing obstacles to capital mobility, reducing risk premiums and performing institutional reforms. Obviously, such an environment provides interesting opportunity to estimate effects of reforms on the real interest rate convergence.
The fact that we are dealing with developing countries should indicate that there might be a case for linear mean reversion, while numerous institutional reforms (EU and EMU enlargement) might indicate possibility of structural breaks or nonlinear convergence (transaction costs).
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Real Interest Parity in New Europe
