" Political Risk Contributes to Post-Crisis Violations of Covered Interest Parity"

Abstract : The large and persistent deviations in covered interest parity (CIP) observed after the global financial crisis presents a puzzle to international finance, given usual arbitrage opportunities. This paper suggests that a country’s political risk is an under-explored factor in determining the cross-currency basis (CCB), a measure of such deviations. Using data for 33 advanced economy (AE) and emerging market (EM) currencies, this paper introduces country-specific political risk into the CIP condition, and tests if such risk matters for the CCB. To address endogeneity, we employ a duration-to-election indicator, together with a measure of democratic accountability, as instruments to identify the effects of political risk. We find that higher political risks do contribute to more negative bases, consistent with the expanded theory. Further explorations indicate that political risks contribute differentially to CIP deviations for AEs versus EMs, with international reserves helping relieve the effects of dollar scarcity on political risk in the latter group.