Exchange rates and market interest rates are closely related in emerging market economies (EMEs). A stronger currency goes hand in hand with lower market interest rates and generally looser financial conditions. A weaker currency is associated with higher market interest rates and tighter financial conditions.
The paper lays out a framework where the exchange rate affects domestic market interest rates through the investment decisions of global investors, even when the market interest rates are those on bonds issued in domestic currency. In an empirical investigation of 14 EMEs, the analysis points to the shifts in market interest rates as arising from shifts in risk-taking attitude of investors.
An appreciation of an EME currency against the US dollar compresses both the local currency and foreign currency sovereign bond spreads of the EME. Here, the relevant exchange rate is the bilateral US dollar exchange rate, not the trade-weighted effective exchange rate. Such compression in yield spreads is driven by the decrease in the credit risk premium. Also, an appreciation of EME currencies against the US dollar that is unrelated to the effective exchange rate significantly increases the EME domestic credit and output, while an isolated appreciation of the effective exchange rate has contractionary effects.
In emerging market economies, currency appreciation goes hand in hand with compressed sovereign bond spreads, even for local currency sovereign bonds. This yield compression comes from a reduction in the credit risk premium. Crucially, the relevant exchange rate involved in yield compression is the bilateral US dollar exchange rate, not the trade-weighted exchange rate. Our findings highlight endogenous co-movement of bond risk premia and exchange rates through the portfolio choice of global investors who evaluate returns in dollar terms.
JEL classification: G12, G15, G23
Keywords: bond spread, capital flow, credit risk, emerging market, exchange rate
Read the full paper at: https://www.bis.org/publ/work775.htm