Simon Lloyd, Giancarlo Corsetti and Emile Marin
A striking regularity around global economic crises is that the dollar tends to appreciate sharply against emerging market (EM) currencies as capital flows out of EMs. In this respect, the adjustments observed since the onset of the COVID pandemic are no exception. Since the end of February, EM currencies have depreciated by around 15% (on average) and non-resident portfolio outflows from EMs summed to nearly $100 billion over a period of 45 days.
In a recent CEPR e-book chapter, we compare recent exchange rate moves and capital flow adjustments to past global crises. To illustrate our findings, Figure 1 plots EM capital flows (in black) alongside EM ‘exchange rate risk premia’ (in purple) — a measure of the profits earned by taking a long position in EM currency-denominated bonds and a short one in US dollar-denominated bonds.
The correlation between capital flows and exchange rate risk premia is close to zero when calculated over the whole period — just 0.08 for 2005-2020. This result is often highlighted by the literature on the ‘exchange rate disconnect’, stressing the apparent weak relationship between currencies and economic fundamentals, including capital flows. However, the correlation becomes strongly positive around crises. In Figure 1, the shaded areas highlight the periods in which the correlation rises to above 0.75 over a 6-month period. Thus, our results contribute to growing evidence that, while the link between currencies and capital flows may be weak on average (‘disconnect’), it can be strong during periods of global distress (‘reconnect’).
Figure 1: EM capital flows and exchange rate risk premia (ERRP)
Note: 6-month moving average of monthly non-resident portfolio flows to Ems (black) and 1-month ex post EM exchange rate risk premia (ERRP) vis-à-vis US dollar (PPP-weighted) (purple) from Jan 2005 to Mar 2020. Shaded areas denote periods in which 6-month rolling correlation of raw capital flows and exchange rate risk premia exceed 0.75. Data Sources: Datastream, IIF, IMF International Financial Statistics.
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