13 Some heavily indebted countries have attempted to reduce the premium on new loans by effectively splitting the market and offering new investors preferred status, either by preferential servicing of some instruments to which international as well as domestic investors have access (for example Uruguay's dollar denominated Treasury bills), or by collateralizing new flows (see World Debt Tables 19,2Q2-1.pp. 35-36 for a discussion of Mexican borrowers use of cjllateral). This approach has met with varying success, depending on the perception of country's ability to provide preferred status.

Does cipital account liberalization result in uncovered interest parity in practice? To study this question, a number of analysts have added an error term to equation (1) and estimated variants of the resulting equation. Of course, such estimates have a number of problems. First the interest rates - must be free, not fixed by the government this is usually true in industrialized economies, but often not the case in developing economies (See Hanson and Neal). Second, an expectations mechanism must be described to generate a series for the (non-observable) expected rate of devaluation. Thus the estimate is a joint test of the equation and the hypothesized expectations function. The usual hypothesized mechanism for generating expectations is some version of rational expectations. Another approach is to use the covered interest parity equation to generate a test of the equality between the expectation of the future spot rate and the forward rate (See Cumby and Obstfeld (1984)). This however, does not strictly test uncovered interest parity, but 'covered' interest parity. It also depends on a forward market in which there is minimal government intervention and to which there is widespread access, not usually common in developing countries.

Most studies of uncovered interest rate parity relate to industrial countries or Eurocurrency rates (for example, Cumby and Obsteld (1981, 1984), Dooley and Isard, Frenkel and Levich (1975, 1977, 1981), Hansen and Hodrick (1980, 1983), Hartman). Only a few relate to developing countries (for example, Blejer (Argentina), Hanson and De Melo (Uruguay), Lizondo (Mexico), World Bank ('984) (Colombia)) and few cover the period since the secondary market developed.

The general result of the studies of industrial countries is that uncovered interest parity does not hold, except perhaps in the EIuro-currency markets, where the assets have similar default and political risk characteristics. The explanations for this failure of uncovered interest parity are varied. Since many studies use the covered interest arbitrage condition to reduce the test to the unbiasedness of the forward rate as a predictor of the future spot rate, one strand of argument relates to econometric problems with the use of spot and forward rates (See Cumby and Obstfeld, (1984)). Another strand of - argument relates to the "peso problem" if agents expect intervention or a sharp change to occur, but it does not materialize in the sample period, then the forward exchange rate will not be an unbiased predictor of the spot rate in the sample. (See for example the discussion in Hansen and Hodrick). Finally, Dooley and Isard argue from the persistent differential between the Eurodollar and domestic German interest rate, that significant risk of capital controls or other political risks could invalidate uncovered interest parity. The last explanation is probably the most important for the developing countries: there may be a substantial and time varying risk premium between domestic and international interest rates. This argument does not, however, invalidate the argument that access to international capital markets can reduce domestic interest rates.<sup>19</sup> I" Some authors also **test** the equality of **real** interest **rates** (See for **example,** Cunrry **and** Mishkin, Mishkin, and Cunby and Ostfeld (1984) and works cited ther, and, for developing countries, Blejer and **Gil L£iaz (Uugusy).** 'tn light of the rather **trong** rejections of uncovered parity and ar _ante_ purchasing **power** parity, it **is** not **surprisbig** that **moat** of thes tws reject the hypothesis that expected real rates **are equal across** currencies. Nonetheless, the bilateral correlations computed by Cumby **and Mishkin** (1985) **show that cx** ante **real rates** tend to move together, even when defined using onshore interet rates. (Obstfeld pp. **_65)_**