Technology shocks and covered interest parity deviations in emerging market economies

Abstract

We examine the response of covered interest parity (CIP) deviations in emerging markets (EMs) to output-enhancing technology shocks. Our model emphasizes three possible scenarios. First, if gains in domestic output are affected more strongly by external technology shocks than by domestic technology shocks, CIP deviations enlarge (i.e., basis widens). Second, if domestic output gains are supported more strongly by domestic technology shocks than by external technology shocks, CIP deviations shrink (i.e., basis tightens). Third, if domestic output gains emanate from equally domestic and foreign technology shocks, then CIP deviations vanish (i.e., magnitude of basis shrinks to zero). In the empirical part, we find that the response of CIP deviations to technology shocks is mostly positive across tenors but sometimes mixed. This positive response is consistent with the second scenario: Technology shocks that enhance domestic output and tighten the basis in EM are more domestic than external.