Testing the UIP Hypothesis-Using Data from Partially Dollarized Developing Countries

Abstract

Unlike studies relying on data from industrial countries, recent studies using data from partially dollarized developing countries have found a favorable result to the uncovered interest parity hypothesis (UIP). In this paper, we test the robustness of these results using data from partially dollarized countries with higher and more volatile inflation rate (Tanzania and Uganda) than the countries covered in previous literature on developing countries. We find that UIP does not hold in Uganda and Tanzania. In fact, unlike previous studies on developing countries, we find that the currency with the higher interest rate appreciates, i.e., there is a forward premium puzzle. We also find that the coefficients will be less biased if we use international dollar interest rates rather than domestic ones. This tells us that capital controls do not play much of a role in these countries. In addition, we test whether the higher liquidity of the currencies of trading partners will improve results in favor of UIP. The results do not provide a clear conclusion. We find less bias when using the Kenyan shilling and more bias when using the South African rand compared to the U.S. dollar.

The anomalous forward premium of EUR/RSD exchange rate

“…On a monthly overlapping basis, the null hypothesis that = 1 can be strongly rejected for seven out of nine currency pairs. Mengistu (2014) uses data from partially dollarized countries with higher and more volatile inflation rate, and finds that UIP also does not hold in these cases, showing strong evidence of a Forward Premium Puzzle.…”