Exchange Rates, Foreign Currency Exposure and Sovereign Risk

43 Pages Posted: 14 Dec 2021

See all articles by Kerstin Bernoth

Kerstin Bernoth

German Institute for Economic Research (DIW Berlin)

Helmut Herwartz

University of Kiel - Institute of Statistics and Econometrics

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2021

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) and conditional on 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. The direction and size of the response of sovereign risk to FX rate movements depend on the considered type of exchange rate measure 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, when looking at the nominal effective exchange rate that is unrelated to changes of USD exchange rate, we find in general no significant effect. 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’. Moreover, we confirm the prime role of the currency mismatch of the non-public sector for the strength of the ‘financial channel’.

Keywords: Exchange rates Sovereign risk, Foreign currency exposure, Structural VAR, Emerging Market, Data-based identification

JEL Classification: C32, G12, G15, G23

Suggested Citation

Bernoth, Kerstin and Herwartz, Helmut, Exchange Rates, Foreign Currency Exposure and Sovereign Risk (October 1, 2021). Journal of International Money and Finance, Vol. 117, 2021, Available at SSRN: https://ssrn.com/abstract=3979537

Kerstin Bernoth (Contact Author)

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

Helmut Herwartz

University of Kiel - Institute of Statistics and Econometrics ( email )

Olshausensrabe 40-60
D-24118 Kiel
Germany

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