Default expectations and currency movements

In fixed exchange rate systems, default risks tend to have devastating effects on currencies, usually leading to sharp devaluations. However, little is known about the relationship between default expectations and exchange rates in floating rate regimes. This column uses data from a broad set of currencies to uncover a strong link between exchange rate movements and sovereign risk across all exchange rate regimes. This relationship is largely caused by countries’ exposure to global sovereign risk factors and shown to be driven by changes in default expectations.