UNIVERSITY OF ILLINOIS LIBRARY AT URBANA-CHAMPAIGN BOOKSTACKS 2-3 524 £ Digitized by the Internet Archive in 2011 with funding from University of Illinois Urbana-Champaign http://www.archive.org/details/testingcapitalac92159malo Faculty Working Paper 92-0159 The Library o^1 the SEP 2 2 Testing Capital Account Liberalization Without Forward Rates: Japan and Chile in the 1970's William F. Maloney Department ofEconomics Bureau of Economic and Business Research College ofCommerce and Business Administration University of Illinois at L'rbana-Champaign BEBR FACULTY WORKING PAPER NO. 92-0159 College of Commerce and Business Administration University of Illinois at Qrbana-Champaign September 1992 Testing Capital Account Liberalization Without Forward Rates: Japan and Chile in the 1970's William F. Maloney Department of Economics Testing Capital Account Liberalization Without Forward Rates: Japan and Chile in the 1970's* William F. Maloney University ofIllinois Urbana-Champaign August 24, 1992 Abstract: The paper presents an alternative to tests of Covered Interest Parity for establishing the impact of liberalizing the capital account when credible proxies for expectations ofdepreciation are not available. A model of domestic interest rate determination during liberalization is tested using a variety of tests for structural break on the Japanese experience in 1979-80 first with, then without, a foreign return with identical inferences. It is then applied to the Chilean liberalization from 1979-82 for which forward rates are not available. It is shown that Chilean interest rates behave as if determined domestically, despite vast inflows, until very late in the reform period. The way in which capital enters an economy, and particularly the elasticity of inflows with respect to interest differentials, is confirmed to be more important than the amount in determining whether interest parity will hold. My thanks to Richard Meese, Dale Henderson, Menzie ( limn. Ana Dolores Novaesand Helen Popper for helpful commentson earlier versions and to Hernando Vargas for inspired research assistance. I also gratefully acknowledge financial support from the Tinker Foundation and the University ofIllinois Research Board.