Exchange Rate Flexibility across Financial Crises

This paper studies the impact of global financial turmoil on the exchange rate policies in emerging countries. Many emerging countries have loosened the link of their currencies to the US dollar since the bursting of the subprime crisis in July 2007. Spillovers from advanced financial markets to currencies in emerging countries stem from the same causes documented in the literature on contagion, such as the drying-up of investors' liquidity, the rise in risk aversion, and the updating of their risk assessments. Consequently, interdependencies across currencies are likely to be exacerbated during crisis periods. To test this hypothesis, we assess the exchange rate policies by their degree of flexibility, itself proxied by the exchange rate volatility, and investigate their relationship to a global financial stress indicator, measured by the volatility on global markets. We introduce the possibility of non-linearities by running smooth transition regressions (STR) over a sample of 21 emerging countries from January 1994 to September 2009. The results confirm that exchange rate flexibility does increase more than proportionally with the global financial stress, for most countries in the sample. We also evidence regional contagion effects spreading from one emerging currency to other currencies in the neighboring area.