The paper shows how-in a Merton-type model with bankruptcy-the currency composition of debt changes the risk profile of a company raising a given amount of financing, and thus affects the cost of debt. Foreign currency borrowing is cheaper when the exchange rate is positively correlated with the return on the company's assets, even if the company is not an exporter. Prudential regulations should therefore differentiate among loans depending on the extent to which borrowers have "natural hedges" of their foreign currency exposures.

We introduce a new measure of emerging market sovereign credit risk: the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross-currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign currency-denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and lower sensitivity to global risk factors. We discuss several major sources of credit spread differentials, including positively correlated credit and currency risk, selective default, capital controls and various financial market frictions.

This update of the guidelines published in 2001 sets forth the underlying framework for the Reserves Data Template and provides operational advice for its use. The updated version also includes three new appendices aimed at assisting member countries in reporting the required data.

Emerging countries experience real exchange rate depreciations around defaults. In this paper, we examine this observed pattern empirically and through the lens of a dynamic stochastic general equilibrium model. The theoretical model explicitly incorporates bond issuances in local and foreign currencies, and endogenous determination of real exchange rate and default risk. Our quantitative analysis replicates the link between real exchange rate depreciation and default probability around defaults and moments of the real exchange rate that match the data. Prior to default, interactions of real exchange rate depreciation, originated from a sequence of low tradable goods shocks with the sovereign’s large share of foreign currency debt, trigger defaults. In post-default periods, the resulting output costs and loss of market access due to default lead to further real exchange rate depreciation.

Changes in domestic and international economic conditions affect partly the trend and volatility of the exchange rate as well as the operating conditions of firms and corporations. Therefore, the common practice of adding up the default risk and currency risk premia could overstate the risk compensation received by investors. Modern approaches to model default risk that incorporate foreign exchange effects while promising may be difficult to implement due to data limitations. This paper addresses the needs of practitioners by presenting a simple rule of thumb, based on the joint dynamics of exchange rate changes and the spreads of credit default swaps, to convert foreign-currency denominated spreads to local currency-denominated spreads adjusting for currency risk. The rule of thumb, while simple, captures the nonlinear dependence between default risk and currency risk, and could be very useful for investors in local currency instruments.

References to policy credibility, particularly with regard to fiscal policy, are ubiquitous in both economic literature and financial markets, even though it is not directly observable. The case of the EU new member states (NMS)-emerging markets joining a supranational entity that is generally considered to have higher policy credibility-provides a unique experiment to assess the effects of credibility on sovereign credit. This paper examines the impact of EU accession on three key variables that can reflect in varying degrees policy credibility: sovereign ratings, foreign currency spreads, and local currency yields. The results suggest that the NMS appear to have enjoyed higher credibility compared to their peers.

For about three decades until the Global Financial Crisis (GFC), Covered Interest Parity (CIP) appeared to hold quite closely—even as a broad macroeconomic relationship applying to daily or weekly data. Not only have CIP deviations significantly increased since the GFC, but potential macrofinancial drivers of the variation in CIP deviations have also become significant. The variation in CIP deviations seems to be associated with multiple factors, not only regulatory changes. Most of these do not display a uniform importance across currency pairs and time, and some are associated with possible temporary considerations (such as asynchronous monetary policy cycles).