Description

Exchange rate movements in emerging market and developing economies (EMDEs) can reflect shifts in macroeconomic fundamentals or, alternatively, financial shocks that impair currency market functioning. Distinguishing between these fundamental and non‑fundamental drivers is central to the IMF's Integrated Policy Framework (IPF) and to assessing when foreign exchange (FX) intervention may be appropriate to smooth currency risk premia. This Staff Discussion Note develops an empirical framework to distinguish between these two types of drivers using deviations from uncovered interest parity (UIP), which capture currency risk premia and limits to arbitrage. Using 15 years of monthly data from 25 EMDEs, the paper documents stylized facts on UIP premia and introduces a toolkit that combines macro‑financial data, model‑based sign restrictions, and narrative evidence to identify episodes in which exchange rate movements are driven by financial shocks rather than fundamentals. Applications to Chile and Brazil show that such financial shock driven episodes account for around one third of UIP premium fluctuations—but are associated with sizable contractions in economic activity. The framework can be applied both retrospectively and in real time, providing policymakers with a structured approach to interpreting exchange rate pressures.

More publications in this series: Staff Discussion Notes