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Capital Controls and Interest Rate Parity:

Evidences from China, 1999-2004∗

March 2005

Li-Gang Liu and Ichiro Otani

Abstract

This paper shows that deviations estimated from the uncovered interest rate parity

condition present strong unstationarity and persistency, thus indicating China’s capital

controls is still effective in driving a wedge between onshore and offshore returns.

Similar results are also obtained from covered interest rate parity condition. Our findings

also demonstrate that there is no evidence of money market integration with Hong Kong.

However, the deviation also shows signs of moderation over time because of increased

pace of capital account liberalization.

Key Words: Capital Controls, Interest Rate Parity, Financial Integration

JEL Classification: F31, F36

∗

The authors are senior fellow and international consulting fellow, Research Institute of

Economy, Trade, and Industry, respectively. The paper is prepared for the

RIETI/BIS/BOC Conference on Globalization of Financial Services in China:

Implications for Capital Flows, Supervision, and Monetary Policy” on Saturday 19th 2005.

The views expressed here are those of the authors alone and do not represent the views of

the institution with which they are affiliated.