Integration or Independence? An Alternative Assessment of Real Interest Rate Linkages in the European Union

The relationship between national real interest rates provides a valuable insight into the extent of economic and financial integration between countries. This paper tests for long-run parity in ex post real interest rates among the major European Union (EU) countries over the period 1979-2003. The empirical investigation, however, is based on an alternative approach. Strong parity is determined by whether or not the first largest principal component (LPC), based on real interest rate differentials with respect to a chosen base country, is stationary. The qualitative outcome of the test is invariant to the choice of base country, and compared with alternative multivariate tests for long-run parity, this methodology places less demands on limited data sets. Strong evidence of onshore parity occurs during 1979-1990 and 1993-2003 with the half-life of a deviation to parity that varies towards 6 months. There is no evidence of long-run parity among EU members during 1990-1993 despite the easing of remaining capital controls in 1990. Parity is rejected for a sample of non-EU countries throughout the study period. Copyright Banca Monte dei Paschi di Siena SpA, 2005