What is your answer to the question: How Close to Full Capital Mobility Are We?
It’s got to depend on what countries are involved, what time horizon, etc. In a recent paper entitled “Measuring Financial Integration:
More Data, More Countries, More Expectations”, Hiro Ito and I tackle this question of mobility and substitutability (terminology due to Frankel), relying upon a key decomposition:
The items in the [square bracket] and <angle bracket> are relevant to the question of why interest rates, adjusting for expected exchange rates, differ. Frankel (1983) defined zero covered interest differentials as full capital mobility, and zero exchange risk premium as full capital substitutability, and in this discussion I retain this terminology, and associated decomposition.
Covered interest differentials used to be attributed to the presence of capital controls, or the threat of imposition thereof. More recently, they can arise (in the real world) because of capital requirements and other regulatory-induced frictions, associated liquidity issues, as well as default risk. Exchange risk premium — the deviation between forward discount and expected depreciation — is associated with the risk of holding a currency, in earlier times modeled as return covariance with wealth, or more recently (1990’s) with return covariance with consumption growth.
By the criterion of covered interest parity holding, mobility seems to have decreased in the wake of the Global Financial Crisis, as this graph from Cerutti et al. indicates.
Figure 1: Covered interest differentials, bps. Source: Cerutti et al. (2021).
While financial capital is now less free to move, it’s important to understand that to a certain extent, this development is intentional; that is the deviations in recent years are partly driven by capital requirements that are aimed at reducing the likelihood of crises in short term credit markets (see discussion in Wu and Schreger, 2021). For six emerging markets, where different factors come into play, see the paper by Geyickzi and Ozyildirim (2021, JIFMIM 2023).
For the second item, relating to exchange risk, we forego the rational expectations assumption and use survey data to evaluate the size of exchange risk premia at short horizons (3 months), and find that over the past three decades, they have generally decreased, for major currency pairs. On the other hand, for emerging market and developing country currencies (against the USD), there’s been little change on average over the past two decades.
Figure 2: Average absolute uncovered interest differential for advanced economy currencies (blue), for emerging market currencies (tan), annualized. Calculated using survey data. Source: Chinn and Ito (2023).
These are measures of deviations from CIP and UIP. They do not directly inform the question of “what’s the slope of the BP=0 schedule” in the IS-LM-BP=0 model. But they do suggest that the BP=0 line is unlikely to be perfectly flat, even for advanced economies where capital controls are absent.
Lecture notes on IS-LM-BP=0 (aka Mundell-Fleming) here: