Covered Interest Parity and International Financial Integration: The Case of India

(ProQuest: . denotes formulae omitted.)IntroductionFinancial integration and openness are often used interchangeably. It is, however, important to distinguish between the two. Financial openness relates to the removal of restrictions on international capital movements. These restrictions may be market-based or administrative. It can also include reduction of discriminatory measures against foreign financial institutions operating in domestic markets. The definition of financial openness can be extended to include the introduction of measures to attract foreign capital. Therefore, financial openness is synonymous with capital account liberalization.Financial integration is achieved when domestic financial markets become part of the world market thus synchronizing interest rate movements, savings and investment activities and the accumulation of physical capital stocks. There will then be free movement of capital across countries whenever interest rate differential emerges, because the marginal product of capital will be different, thus implying an arbitrage opportunity. This movement of capital ensures the availability of capital in economies where the domestic savings are not adequate for domestic investments.A study done by Le (2000) revealed that merely opening up the economy in terms of financial liberalization is not enough to ensure financial integration. In fact, openness without market-oriented integration can be harmful for an economy striving in the path of economic growth and development. Financial integration, on the other hand, cannot be established without financial openness. Financial openness is, therefore, the means and not the end. It is financial integration that is the end objective for a developing economy seeking benefits from globalization. According to Batavia et al. (2003), a gap between financial openness and financial integration can become responsible for a crisis in the country. There is empirical evidence for this in the various crises, which have occurred in Southeast Asian economies and Argentina, Mexico etc. These were a result of a gap between financial openness and financial integration. The Southeast Asian economies tried to eliminate this gap in the road to recovery from the crisis. Malaysia eliminated this gap by reducing financial openness or by imposing capital controls. Thailand and Korea, on the other hand, tried to reduce this gap by increasing financial integration. It is, therefore, important to measure this gap. Different studies use different measures of capital account openness. Most of these studies, however, rely on one source of data AREAER (Annual Report of Exchange Arrangements and Exchange Restrictions) reported by the IMF. In the case of financial integration, however, there are two main measures used-covered interest rate parity and uncovered interest rate parity. The main objective of this study is to investigate the efficiency of financial markets in facilitating integration between the money market and foreign exchange market in India. This is important because financial integration is essential in order to acquire more funds for investment in an economy striving towards achieving 10% growth rate.This study is an attempt towards investigating the extent of financial integration in India, using the indicator of Covered Interest Parity (CIP). The study is focused on CIP in the case of INR (Indian Rupee)-denominated assets and USD (US Dollar)-denominated assets. This is important for a country opening up its capital account of the Balance of Payments statement and moving towards 'Fuller Capital Account Convertibility'. Literature ReviewMeasures of Financial IntegrationFinancial integration can be measured using measures of Uncovered Interest Parity (UIP) and CIP.Interest Rate ParityFor both UIP and CIP, it is interest rate differential on assets denominated in two different currencies comparable in terms of maturity and risk which is important. …