Global financial risk, the risk-taking channel, and monetary policy in emerging markets

Abstract

How does emerging markets’ (EMs) monetary policy respond to global financial risk (GFR) shocks? Despite the broad literature focusing on EM monetary policy dynamics, the existing evidence on the cyclicality and drivers of EM monetary policy response to GFR shocks is still inconclusive. Using macro-financial data from four inflation targeting EMs and a small-open economy SVAR model, we provide a clear pattern of EM monetary policy response to GFR shocks by highlighting the novel role of the risk-taking channel and identifying the drivers of EM monetary policy response. We find that EM monetary authorities initially respond procyclically to GFR shocks, due to movements in sovereign risk and exchange rate that threaten financial stability through a risk-taking mechanism. This (initial) procyclical policy response can also be explained by the observed inflation dynamics and liability dollarization. Finally, our results also document a novel role of sovereign risk in EM exchange rate dynamics. • Evidence on EM monetary policy response to GFR shocks is inconclusive. • Previous studies also overlook the role of the risk-taking channel. • This study fills this gap by providing a key role of the risk-taking channel. • This channel forces EM authorities to respond procyclically to GFR shocks. • Sovereign risk plays a novel role in EM exchange rate dynamics.