Contagion and linkages across international currencies

Abstract

This paper examines dynamic linkages among international currencies in the face of several turmoil episodes including the global financial crisis (GFC), eurozone sovereign debt crisis (ESDC) and the recent COVID-19 pandemic. We utilize weekly data from August 2005 till December 2022. Our empirical strategy consists of identification of crisis periods using a Markov-switching VAR, followed by estimation of the dynamic conditional correlations using an ADCC-GARCH model and testing for the impact of the crises using a regression model with robust standard errors. We compare impact of the episodes on the dynamic correlations across the currency pairs. Our findings suggest that correlation between developed economy exchange rates increased significantly during these episodes implying existence of a contagion effect. While significant negative correlation coefficients were observed across all pairs with Japanese Yen during GFC and ESDC, indicating flight to quality. We analyse factors that may be responsible for changes in co-movement of the currencies during the study period and find that financial stress, emergence of the pandemic and geo-political risk have a significant role to play.