Interest Parity Conditions as Indicators of Financial Integration in East Asia

Market participants and policymakers have a growing interest in the development of East Asian financial markets, and to the extent to which these markets are open and influenced by world markets. This paper examines the information contained in interest parity conditions about the international integration of a wide range of economies in East Asia. Legal restrictions on the capital account and tests of covered, uncovered and real interest parity are presented in some detail. Using standard regressions, cointegration analysis and error decompositions, it is argued that uncovered interest parity tests reveal a surprisingly large amount of information about financial openness. For example, McCallum’s (1994) model of the interaction of uncovered interest parity and a monetary policy reaction function can be used to explain striking anomalies that arise between countries. Openness and the importance of foreign interest rate shocks appear to have increased in most countries, although Korea remains an important exception. Four policy implications are discussed in the conclusion.