Bank for International Settlements study finds EMEs with high foreign currency debt and shallow FX markets track US monetary surprises

The Bank for International Settlements published a Quarterly Review article examining how emerging market economy (EME) central banks with floating exchange rates respond to external shocks, focusing on US monetary policy surprises. It finds that EMEs combining high external foreign currency debt with shallow foreign exchange (FX) markets tend to move policy rates in the same direction as US surprises and also use FX intervention, with the overall policy mix associated with smaller exchange rate moves than in other EMEs. Using a panel of 10 EMEs from January 2000 to January 2020, the study measures foreign currency and local currency external portfolio debt exposures and proxies FX market depth with a rolling median FX spot bid-ask spread. Local linear projections indicate an average policy rate pass-through of about 60% over 28 days that is not statistically significant, while economies with larger US dollar-denominated external debt show roughly one-for-one pass-through, rising to nearly twice the US surprise for countries with both high US dollar debt and illiquid FX markets. FX intervention, proxied via reserve changes adjusted for valuation and other effects, is deployed on average in the month after Federal Open Market Committee announcements and is more than twice as large in thin FX markets, while external debt levels do not materially change the propensity to intervene. By contrast, higher external local currency debt does not coincide with stronger rate or intervention responses and is associated with larger currency depreciation following US monetary policy surprises.