…Extending our previous work (Aizenman et al. (2015)), we devote special attention to the impact of currency weights in the implicit currency basket, balance sheet exposure, and currency composition of external debt. Our results support the view that there is no way for countries to fully insulate themselves from shocks originating from the CEs. We find that for both policy interest rates and the real exchange rate (REER), the link with the CEs has been pervasive for developing and emerging market economies in the last two decades, although the movements of policy interest rates are found to be more sensitive to global financial shocks around the time of the emerging markets’ crises in the late 1990s and early 2000s, and since 2008. When we estimate the determinants of the extent of connectivity, we find evidence that the weights of major currencies, external debt, and currency compositions of debt are significant factors. More specifically, having a higher weight on the dollar (or the euro) makes the response of a financial variable such as the REER and exchange market pressure in the PHs more sensitive to a change in key variables in the U.S. (or the euro area) such as policy interest rates and the REER. While having more exposure to external debt would have similar impacts on the financial linkages between the CEs and the PHs, the currency composition of international debt securities matter. Economies more reliant on dollar-denominated debt issuance tend to be more vulnerable to shocks emanating from the U.S.
In other words, in contrast to the simplest — one might say simplistic — version of the trilemma thesis, floating exchange rates cannot completely insulate an economy. (In practical discussions, pure insulation is seldom posited.) Nonetheless, the nature of the exchange rate regime does have a measurable impact on the sensitivity of non-core financial variables to core-country financial variables. And that impact interacts with balance sheet variables.