Financial Integration and Exchange Market Pressure

This study examines the role of financial integration on exchange market pressure (EMP) across a representative group of forty-two advanced and emerging markets over the period 2000-2019, which covers the global financial crisis, which has heightened monetary and economic policy uncertainty. We use a novel measure of financial integration, namely the uncovered equity return differential versus the US, which is based on the Uncovered Equity Parity and is available at a monthly frequency. Our analysis is based on panel cointegration and several robustness tests and it shows that indeed financial integration has a significant effect on the EMP of advanced markets as well as emerging markets. Our main results include: (i) There is a long-run relationship between financial integration and EMP; (ii) Financial integration reduces EMP in the case of emerging markets and increases EMP in the case of advanced markets reflecting the empirical results on the validity of Uncovered Equity Parity for the latter group of countries; (iii) The speed of adjustment to long-run equilibrium is very fast undermining the results of previous studies based on lower frequency data; (iv) The impact of financial integration is sustained when taking into account real integration, and economic policy uncertainties; (v) Financial integration continued to impact EMP even during the global financial crisis; and (vi) Financial integration has a decreasing impact on EMP across both emerging and advanced markets when the countries adopt a flexible exchange rate regime