Academic journal article Quarterly Journal of Finance and Accounting

Sovereign Risk Channels and Exchange Rates

Academic journal article Quarterly Journal of Finance and Accounting

Sovereign Risk Channels and Exchange Rates

Article excerpt

This paper elucidates the channels through which sovereign risk and exchange rates are related. I show that the channels are different depending on whether a country is classified as an emerging or an advanced economy. Generally for emerging market economies, both local (country-specific political and macroeconomic risk) and global sovereign risk factors (proxied by the VIX) do play a significant role in the depreciation of the local currency relative to the U.S. dollar. For advanced economies, sovereign risk seems to have become important for currency depreciation at a much later date, with political risk becoming prominent in the post 2007-2008 financial crisis era. Global factors also seem to play an important role in the relationship between advanced economy sovereign risk and exchange rates in the post crisis era.

Introduction

Recently, in line with Engel and West's (2005) definition of exchange rates, Delia Corte, Sarno, Schmeling and Wagner (2014) and Coudert and Mignon (2013) provide empirical evidence linking exchange rate returns and currency risk premia to sovereign risk. (1) Delia Corte et al. (2014) find that a 50 basis point increase in sovereign risk (proxied by CDS spreads) leads to a contemporaneous depreciation of that country's exchange rate by about 3.5% with an R squared statistics ([R.sup.2]) of about 22%. This finding is impressive considering the fact that R squared statistics are near zero for most regressions of exchange rates on interest rate differentials, which has traditionally been the benchmark when explaining movements in exchange rates. In addition, they find that sovereign risk predicts returns to not just the carry trades but also to returns on other currency strategies, such as trading volatility, skewness and kurtosis. (2) Similarly, Huang and MacDonald (2014) find that sovereign risk does a better job of explaining exchange rate movements than interest rate differentials or any other economic variable studied in the literature.

Despite the overwhelming recent evidence suggesting that sovereign risk does the best job of explaining exchange rate movements, there is little clarity about the channels through which sovereign risk drives exchange rate movements. The above-mentioned authors all use CDS spreads, an aggregate measure of sovereign risk, to explain movements in exchange rates. This paper seeks to study the channels driving the exchange rate sovereign risk relationship by decomposing sovereign risk into its known components and trying to understand how each of these components drive exchange rate behavior. Sovereign risk can arise from three main sources, namely: macro risk, political risk, (e.g., Bulow and Rogoff (1989); Buiter and Rahbari (2013); Bekaert, Harvey, Lundblad and Siegel (2014)), and risk arising from global shocks (e.g., Gonzalez-Rozada and Levy-Yeyati (2008)). (3) In this short paper, I try to answer two guestions: firstly, through which of these channels are sovereign risks and exchange rates related? Secondly, do these channels differ for emerging economies and advanced economies? The interest in examining the difference in the dynamics of the sovereign risk--exchange rate relationship for advanced and emerging economies stems from the fact that Bansal and Dahlquist (2000) do find that exchange rates of the two sets of economies behave differently. (4)

I find that the channels that drive the relationship between exchange rates and sovereign risk are different, depending on whether a country is an emerging market economy or an advanced economy. For emerging markets, I find that country-specific political risk, as well as the other determinants of sovereign risk, like macro risk and global factors, all significantly explain movements in exchange rates. An increase in any of these determinants of sovereign risk relative to the U.S. leads to a significant depreciation of that country's currency relative to the U.S. dollar. I find that for emerging markets political risk changes have the biggest effect on exchange rates in terms of magnitude. …

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