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Long memory in the interest rates in some Asian countries.

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Abstract

In this paper, the stochastic behavior of short run interest rates in some Asian development countries is examined by means of using fractionally integrated semiparametric techniques. In doing so, a much richer flexibility is allowed in the dynamic behavior of the series not achieved by the classical representations based on I(0) or I(1) processes. The author uses a quasi-maximum likelihood estimation procedure of Robinson [QMLE, 1995a], which has some advantages with respect to other methods. The results show that the orders of integration of the short run interest rates in Singapore and Thailand are strictly below 1, implying mean reversion. On the contrary, the results for Malaysia, South Korea, and Philippines are less conclusive, the values of d oscillating around the unit root case. (JEL C22)

Introduction

The analysis of the persistence of interest rates constitutes a major question in the empirical literature in macroeconomics and finance. In macroeconomics, for example, they are crucial to the conduct of monetary policy, as policy is primarily implemented in most developed countries through the setting of short-term interest rates. Interest rate movements, in turn, have an impact on spending and saving decisions, thereby affecting macroeconomic activity. The finance literature is also prolific in models of, and uses for, interest rates, since their movements are crucial to investment and portfolio decisions.

In modern time series econometrics, it has become standard practice to verify the order of integration of each variable entering the model. Thus, Wu and Chen [2001]; Rose [1988]; Stock and Watson [1988]; Campbell and Shiner [1991]; and others have applied a complete battery of test statistics to determine if short-run interest rates contain unit roots. The alternative is in most cases I(0) stationarity. In theory, it is impossible for interest rates to follow a unit root process without drift, since this would impose no bounds on the movements of such variables; in practice, however, they cannot be negative. If a drift term is included, it is also difficult to justify how interest rates can tend to infinity in the presence of a unit root. This would imply that expected inflation would also follow a random walk, with the consequence that its path cannot be influenced by monetary policy.

On the other hand, the mean-reverting property of the series has major consequences. First, in terms of modelling strategies, either a vector-error correction (VEC) or a vector autoregression (VAR) in differences are not necessary to model the dynamics of short-run interest rates. A simple VAR appears sufficient to represent the dynamic behavior of the series. Second, the rejection of a unit root in the short-run interest rates sheds some light on the empirical investigation of two major relationships in macroeconomics--the Fisher Hypothesis (FH) and the Uncovered Interest Parity (UIP). If interest rates and inflation are found to be I(1) non-stationary, the FH can be tested via cointegration [Mishkin, 1992]. In the case where interest rates are I(0) stationary, the previous analysis is no more appropriate and the presence of a long-run FH is rejected. The stationarity of nominal short-run interest rates has also some consequences on the empirical validation of the UIP. As nominal exchange rates are difference stationary, the validity of the UIP condition requires mean-reverting nominal short-run interest rates.

Empirical investigations have concluded that short-run interest rates are mean-reverting in Europe and in the U.S. [Wu and Chen, 2001; Rose, 1988; Stock and Watson, 1988], implying that FH cannot be investigated via...

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