Abstract
The uncovered interest rate parity (UIP) hypthesis states that if two assets are similar, except their currency of denominations, and have different interst rates, then the currency of the asset with the higher interest rate is expected to depreciate. Unlike studies relying on data from industrial countries, recent studies using data from partially dollarized developing countries have found a favorable result to the hypothesis. This may be because the higher average inflation rate in emerging and developing countries introduces a secular trend to movements in exchange rates, making it easier to predict future exchange rate changes. In this paper, we test the hypothesis using data from partially dollarized countries with higher and more volatile inflation rate (Tanzania and Uganda) than the developing countries covered in previous literature. We find that UIP does not hold in Uganda and Tanzania. In fact, unlike previous studies on developing countries, we find that the currency with the higher interest rate appreciates, i.e., there is a forward premium puzzle. We also find that the coefficients will be less biased if we use international dollar interest rates rather than domestic ones. This tells us that capital controls do not play much of a role in these countries. In addition, we test whether the higher liquidity of the currencies of trading partners will improve results in favor of UIP. The results do not provide a clear conclusion. We find less bias when using the Kenyan shilling and more bias when using the South African rand compared to the U.S. dollar.