PROSPECTS FOR JOINING THE EURO AREA: NEW EVIDENCE THROUGH THE LENS OF THE UNCOVERED INTEREST PARITY APPROACH

The paper investigates the prospects of six European candidate countries for the euro area accession in the light of the uncovered interest rate parity (UIP) theory. Testing the UIP validity is relevant for policymakers since EURO adoption requires exchange rate stability. Using monthly data from May 2002 to March 2021, we provide country-level empirical evidence on the effect of interest rate differentials on the expected exchange rate change. The econometric analysis employs a threshold regression approach by controlling for both the global and country-specific financial stress as threshold variables. The empirical results show that the UIP condition holds, especially during high-financial stress periods such as the COVID-19 pandemic or the Global Financial Crisis. Moreover, domestic financial stress has a stronger discrimination power in validating the UIP condition compared to the global financial stress. UIP holds for only one country (Czech Republic) if considering global financial stress as threshold, and for two countries (Czech Republic and Sweden) if employing Country-Level Index of Financial Stress as threshold.