The impact of economic crises on uncovered interest rate parity

Abstract

This study investigates the validity of Uncovered Interest Parity (UIP) in four major emerging economies—Türkiye, Brazil, Indonesia, and Mexico—using monthly data from 2000 to 2024. UIP theoretically suggests that expected exchange rate changes should fully offset interest rate differentials, leaving no room for arbitrage. However, our results show that this theoretical relationship frequently breaks down in crisis-prone emerging markets. To capture the instability of these economies, we employ structural break tests (Zivot–Andrews and Bai–Perron), which reveal multiple regime shifts across all four countries. These breaks coincide with major episodes of macroeconomic turbulence, such as Türkiye's 2001 and 2018 currency crises, Brazil's 2015–2016 political and economic turmoil, Indonesia's 2018 emerging-market sell-off, and Mexico's 2008–2009 global financial crisis. These findings confirm that UIP must be analyzed within a regime-dependent framework rather than treated as a constant linear relationship. Crisis-period UIP regressions further show that UIP systematically fails in all four countries. Estimated slope coefficients are far from unity and statistically insignificant, indicating that interest rate differentials have very limited predictive power for exchange rate changes. Notably, while earlier evidence suggested that Mexico might partially satisfy UIP during the global financial crisis, our updated results reject this view. Even in Mexico, interest rate hikes fail to stabilize the exchange rate as predicted by theory, highlighting that credibility concerns and risk premia dominate during stress periods. Taken together, these findings underline that UIP does not hold consistently in emerging markets. Structural breaks, recurrent crises, inflation volatility, and weak institutional credibility undermine the parity condition in all four economies studied. The results imply that policy makers cannot rely solely on interest rate adjustments to anchor exchange rate expectations—strengthening institutional credibility and reducing risk perceptions are equally critical to restoring UIP-like behavior.