Exchange rate policy and sovereign spreads in emerging market economies

Abstract

This paper empirically analyzes the relationship between exchange rate policy and sovereign risk premia in emerging market economies, considering both officially declared regimes and actual exchange rate behavior. The results show that countries that announce a fixed exchange rate regime face lower spreads than countries that announce a floating regime or intermediate flexibility. When the actual exchange rate behavior is considered, this relationship persists between intermediate flexibility and pegs but countries that allow their exchange rates to freely float do not face higher spreads. The difference between the results is due to the fact that many countries deviate from their declared exchange rate policy. The countries that announce a floating regime do not face higher spreads than pegs when they actually allow a high degree of flexibility as they announced. However, intermediate flexibility leads to higher spreads independently of whether this is the announced policy or the actual behavior. © 2011 Blackwell Publishing Ltd.