Financial Spillovers to Emerging Economies: the Role of Exchange Rates and Domestic Fundamentals

Abstract

Financial integration of emerging economies is on the rise and so are financial and monetary spillovers, especially those originating from US economic policy decisions and the (related) evolution of the US dollar. We revisit the “trilemma” vs. “dilemma” hypothesis and assess whether, and to what extent, exchange rate regimes and other relevant country fundamentals affect the sensitivity of domestic financial conditions to global risk aversion and US financial conditions. Results for a sample of 17 emerging economies over the period 1990-2018 suggest that the trilemma hypothesis appears to be still valid, as more flexible exchange rate regimes help in mitigating spillovers to stock market returns, sovereign spreads and real credit growth. However, other country fundamentals such as the current account, trade integration and US dollar debt exposure are also important factors.

Keywords: trilemma, global financial cycle, financial conditions, emerging market economies, international policy transmission, spillovers

JEL Classification: E42, E44, E52, F31, F36, F41, G15