The paper revisits the debate over the role of exchange rates and other country-specific economic and financial fundamentals in shaping the sensitivity of domestic financial markets to the global financial cycle in emerging economies. In particular, we look at the sensitivity of equity returns, sovereign spreads, short-term money market rates and the rate of growth of domestic credit. Together with exchange rate regimes, we consider the role of other variables, such as the fiscal balance, the current account balance, the level of dollar-denominated debt, the degree of real and financial integration.
More flexible exchange rates and solid domestic fundamentals tend to mitigate the sensitivity of emerging countries' financial markets to the global financial cycle. The flexibility of exchange rates matters more in mitigating the transmission to equity markets and short-term rates, while other fundamentals, such as the degree of dollar debt exposure, the current account balance and real and financial integration, matter more in shaping the response of sovereign spreads and in the transmission to domestic credit conditions.
