Exchange Rates, Foreign Currency Exposure and Sovereign Risk

TLDR

The study quantifies the causal link between exchange‑rate movements and sovereign risk in 16 major emerging‑market economies using structural vector autoregressive models over 2004‑2016. It employs SVARs with a novel data‑based identification scheme that captures the complex interrelations among exchange rates, sovereign risk, and interest rates. Results show that sovereign‑risk responses to exchange‑rate shocks vary with the exchange‑rate metric and net foreign‑currency exposure: a domestic‑currency depreciation against the USD raises sovereign risk, while a depreciation of the effective exchange rate raises risk only in economies with large negative private‑sector foreign‑currency exposure, indicating that the financial channel dominates over the traditional net‑trade channel.

Abstract

We quantify the causal link between exchange rate movements and sovereign risk of 16 major emerging market economies (EMEs) by means of structural vector autoregressive models (SVARs) using data from 10/2004 through 12/2016. We apply a novel data based identification approach of the structural shocks that allows to account for the complex interrelations within the triad of exchange rates, sovereign risks and interest rates. We find that the direction and size of the response of sovereign risk to FX rate movements depend on the type of exchange rate measure we look at and on the size of the net foreign currency exposure of an economy. A depreciation of the domestic currency against the USD increases sovereign risk. In contrast, a depreciation of the effective exchange rate turns out to have only a significant effect on sovereign risk for countries with large negative net foreign currency exposures of the private sector. In this case, a depreciation of the NEER also induces an increase in sovereign risk. We conclude that the 'financial channel' is more important in the transmission of exchange rate shocks to sovereign risk in comparison with the traditional 'net trade channel'.