The impact of banking and sovereign debt crisis risk in the eurozone on the euro/US dollar exchange rate

Abstract

I study the impact of financial crisis risk in the eurozone on the euro/US dollar exchange rate. Using daily data from 3 July 2006 to 30 September 2010, I find that the euro depreciates against the US dollar when banking or sovereign debt crisis risk increases in the eurozone. While the external value of the euro is more sensitive to changes in sovereign debt crisis risk in vulnerable member countries than in stable member countries, the impact of banking crisis risk is similar for both country blocs. Moreover, rising default risk of medium and large eurozone banks leads to a depreciation of the euro while small banks’ default risk has no significant impact, showing the relevance of systemically important banks with regards to the exchange rate.

Keywords:

• exchange rates
• eurozone
• banking crisis
• sovereign debt crisis
• subprime crisis

JEL Classification::

• F31
• F32
• E44
• E52

Notes

¹ Maltritz (2010) shows that higher payments for bank bailouts may increase sovereign default risk.

² The trade-off of the ECB to fight inflation and/or to ensure macroeconomic stability in the EMU may also be discussed in the context of second-generation currency crisis models (Obstfeld, 1994, 1996).

³ Maltritz (2010) shows for the case of the financial crisis in Hungary in 2008 that higher payments for bank bailouts may increase sovereign default risk.

⁴ As a robustness check I also use equal weighted CDS premium indices in Section III.

⁵ In the regression analysis, in Section III, I also use banking and sovereign debt crisis risk indices for the United States, which are calculated according to the EMU indices.

⁶ The ECB indicated several times that the expansion of money supply associated with the purchases of sovereign EMU bonds would be sterilized. However, the distinction between quantitative easing and the ECB's recent monetary policy is only semantic as sterilization ‘means replacing overnight deposits with the central bank with one-week term deposits’ (Buiter and Rahbari, 2010).

⁷ Chui et al. (2002) employ an open economy version of the Diamond–Dybvig model to explain a liquidity-driven devaluation cum sovereign debt crisis.

⁸ For an analysis of a debt crisis on bank stock prices see, for example, Mathur and Sundaram (1997).

⁹ Analogously to the case of the EMU member countries, I use measures for banking and sovereign debt crisis risk for the United States in order to account for the impact of these crisis risks on the external value of the US dollar.

¹⁰ The majority of papers use GARCH models in order to model exchange rate movements (see, for example, Morales-Zumaqueroa and Sosvilla-Rivero, 2011).

¹¹ A rising exchange rate indicates an appreciation of the euro against the US dollar.

¹² Depending on the specification, the banking and sovereign debt crisis risk variable is used for the vulnerable and/or the stable EMU member countries.

¹³ The financial crisis risk variables are defined according to the risk variables for the EMU outlined in Section II. The individual banks included in the bank CDS premium index are reported in Table A1 in the Appendix.

¹⁴ In order to avoid multicollinearity problems, I do not use two alternative measures of financial crisis risk (banking or sovereign debt crisis risk) in the EMU in one specification.

¹⁵ For vulnerable EMU countries, a one SD increase in bank CDS premiums (Δ) leads to a depreciation of the euro by 0.08%–0.12%. A one SD increase in sovereign CDS premiums (Δ) leads to a depreciation of the euro by 0.07%–0.09%.

¹⁶ For stable EMU countries, a one SD increase in bank CDS premiums (Δ) leads to a depreciation of the euro by around 0.11%. A one SD increase in sovereign CDS premiums (Δ) leads to a depreciation of the euro by 0.04%–0.05%.