Zero interest rate bound and covered interest parity: Evidence from the Australian and the New Zealand dollars

The global financial crisis (GFC) and the following instability in the world economy had enormous impacts on international markets. In particular, covered interest parity (CIP) condition, which was solidly anchored in riskless arbitrage during tranquil periods, was violated substantially during the crises. In the GFC, a flight to quality became serious, so that the role of the US dollar as international liquidity made its interest rate lower on the forward market. However, unlike the other major currencies, the Australian Dollar and the NZ dollar did not show this worldwide feature. In particular, since 2010, these two currencies came to have smaller deviations from the CIP condition than the US dollar.  

The purpose of this paper is to explore what made the Australian Dollar and the NZ dollar so different from the other major currencies in the CIP condition. In the analysis, we focus on a unique feature of Australia and New Zealand where the short-term interest rates remained significantly positive even after the GFC. Unlike in the other advanced countries, short-term interest rates remained significantly positive after the GFC in Australia and New Zealand. Consequently, both Australia and New Zealand became exceptional advanced economies that did not fall into the liquidity trap after the GFC. In the analysis, we explore whether the unique feature made deviations of the Australian Dollar and the NZ dollar from the CIP condition smaller on the forward contract.

In the first part of the paper, we construct a representative agent small open economy model and examine how international liquidity risk is reflected in the CIP condition under the liquidity trap. We show that not only increased liquidity risk but also the zero interest rate bound cause deviations from the CIP condition on the forward contract. In the second part of the paper, we test this theoretical implication through investigating the CIP condition in major currencies. The regression results suggest that various risk measures were useful in explaining the deviations. However, they also imply that the zero interest rate bound was another important determinant for the deviations. The latter result supports our hypothesis that unique monetary policy features in Australia and New Zealand made their CIP deviations smaller on the forward contract.