Convergence of Exchange Rate and Inflation Risk Premiums in the Asian and Central European Emerging Market Economies

Abstract

This study investigates the link between the inflation risk and the exchange rate risk premiums in the six emerging market economies that have abandoned currency pegs and adopted independent monetary policies with flexible exchange rates. These risk premiums are examined in the selected Asian and Central European emerging market economies in the period following the major internatinal financial crisis of 1997-98. The study demonstrates that market interest rates in these countries have in fact responded effectively and proactively to shocks in these two risk premiums. Such responses of short-term market interest rates imply the prevalence of efficient financial markets and prove that monetary policies are capable of providing rational and effective responses to shocks in inflation and exchange rates. A model presenting interactions between both risk premiums is tested with OLS plus ARMA (1,1) as well as TARCH (1,1,1) procedures. The ability to lower these two risk premiums reflects gains in monetary policy credibility and can be viewed as a prerequisite for achieving financial stability in these emerging market economies.

Keywords: inflation risk, exchange rate risk, emerging market economies

JEL Classification: E44, F31, P51