Board of Governors of the Federal Reserve System

June 2012

Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries

Samir Jahjah, Bin Wei, and Vivian Zhanwei Yue

Abstract:

This paper empirically analyzes how exchange rate policy affects the issuance and pricing of international bonds for developing countries. We find that countries with less flexible exchange rate regimes pay higher sovereign bond spreads and are less likely to issue bonds. Quantitatively, changing a free-floating regime to a fixed regime decreases the likelihood of bond issuance by 4.6% and increases the bond spread by 1.3% on average. Furthermore, countries with real exchange rate overvaluation have higher bond spreads and higher bond issuance probabilities. Moreover, such positive effects of real exchange rate overvaluation tend to be magnified for countries with fixed exchange rate regimes. Our results suggest that choosing a less flexible exchange rate regime in general leads to higher borrowing costs for developing countries, especially when their currencies are overvalued.

Keywords: Sovereign bond spread, exchange rate regime, overvaluation, debt crisis

PDF: Full Paper