Foreign Exchange Volatility and its Implications for Macroeconomic Stability: An Empirical Study of Developing Economies

Abstract

This paper studies foreign exchange fluctuations and how they impact both sustainable macroeconomic variables and external debt. Generally, as a “developing” country becomes more globalized through increased international capital flows, both sovereign and private borrowing tends to increase. Debt issued in a foreign currency is affected by the exchange rate as it can raise/decrease borrowing costs. At the same time, instability in the economy and failure to meet debt obligations can be caused by both external and domestic shocks. In this paper, macroeconomic fundamentals, as well as foreign exchange risk and volatility, and credit default are analyzed for both emerging and developing countries. Using a dynamic open economy growth model, excess debt is calculated including the effect of the changes in the value of the currency. The empirical findings of this paper highlight that external credit default risk increases together with greater fluctuations, i.e., volatility, in FX rates, especially in fragile emerging countries, e.g., Brazil, Indonesia, Turkey, and South Africa.