Testing for the Uncovered Interest Rate Parity (UIP) in Developing Countries: The Case of Rwanda

Abstract

The aim of this paper is to assess the link between interest rates and exchange rates in Rwanda under the framework of uncovered interest rate parity (UIP) hypothesis.The parity condition states that the difference between the interest rates of two countries is equal to the expected depreciation between the countries’ currencies. The paper uses data spanning the January 2004 to December 2016 period. The paper uses the spot exchange rate, risk premium, deposit interest rates as domestic variables while the USA deposit rates are used as foreign interest rates.

Due to its desirable properties especially in terms of handling rational expectations models, the Generalized Method of Moments (GMM) is used to estimate the UIP equation for Rwanda before carrying out several others diagnostic tests to assess the robustness of results. Empirical results show that interest rate differentials, risk premium and the intercept are statistically not significant. These results imply that the UIP condition does not hold for Rwanda under the period of study, which is consistent with other empirical findings in developing countries.

The lack of empirical support for the UIP hypothesis in Rwanda may open up arbitrage opportunities for investors with rational expectations.Indeed, the Modelling and forecasting team should review the UIP equation in the Forecasting and Policy Analysis System (FPAS) macro-model so as to give more attention to non-interest sensitive determinants of exchange rate dynamics in Rwanda.

Keywords: Uncovered Interest rate Parity (UIP), Generalized Method of Moments (GMM)

JEL Classification: C2, E4, E6, F2, F4