What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?
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What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia? Gee Hee Hong 1 & Anne Oeking 1
& Kenneth
H. Kang 1 & Changyong Rhee 1
# Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Asian countries have high demand for US dollars and are sensitive to US dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow US dollars or other currencies on a hedged basis via the cross-currency swap markets. These deviations can be explained by regulatory changes since the GFC, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of US dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while eases financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market, or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when US dollar funding markets come under stress. Keywords Covered interest parity . Limits to arbitrage . US dollar funding . FX swaps
1 Introduction The covered interest parity (CIP) is a non-arbitrage condition where the covered interest differential between two assets denominated in different currencies should equal to zero. This non-arbitrage condition holds in a frictionless FX swap market, as an We would like to thank Eugenio Cerutti, Will Kerry, Peichu Xie, Yizhi Xu, Aki Yokohama, participants in the IMF APD seminar and RES/MCM surveillance meeting, and two anonymous referees for valuable comments and suggestions. We would like to also thank Ananya Shukla for excellent research assistance, Dulani Seneviratne for data support and Weicheng Lian for sharing Stata code. The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
* Anne Oeking [email protected] 1
International Monetary Fund, Washington, DC, USA
Hong G.H. et al.
investor raising foreign currency in the cash spot market should have the same payoffs as in the forward market. Otherwise, riskless arbitrage opportunities would arise, reflecting inefficiencies in the international capital markets. One of the most striking features in international finance since the global financial crisis (GFC) is that the covered interest parity fails to hold for numerous currencies vis-à-vis the US dollar. This is quite striking, as CIP for the most part held true prior to the GFC (Fig. 1).1 A more puzzling aspect is that the breach of CIP was not a temporary phenomenon, specific to the fina
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