The Pass‐through of Exchange Rate in the Context of the European Sovereign Debt Crisis

• Published date: 01 April 2016
• Date: 01 April 2016
• Author: Nidhaleddine Ben Cheikh,Christophe Rault
• DOI: http://doi.org/10.1002/ijfe.1539

THE PASS-THROUGH OF EXCHANGE RATE IN THE CONTEXT OF THE

EUROPEAN SOVEREIGN DEBT CRISIS

NIDHALEDDINE BEN CHEIKH

a

and CHRISTOPHE RAULT

b,

*

a

ESSCA School of Management, Angers, France

b

Department of Economics, University of Orléans (LEO, UMR CNRS 7322), Orléans, France

ABSTRACT

This paper investigates whether exchange rate pass-through (ERPT) into import prices is a nonlinear phenomenon for five

heavily indebted Euro area countries, namely the so-called GIIPS group (Greece, Ireland, Italy, Portugal and Spain). Using

logistic smooth transition models, we explore the existence of nonlinearity with respect to sovereign bond yield spreads (versus

the German bund) as an indicator of confidence crisis/macroeconomic instability. Our results provide strong evidence that the

extent of ERPT is higher in periods of macroeconomic distress, that is, when sovereign bond yield spreads exceed a given

threshold. For almost all the GIIPS countries, we reveal that the increase in macroeconomic instability and the loss of confidence

during the recent sovereign debt crisis have entailed higher sensitivity of import prices to exchange rate movements. For

instance, the rate of pass-through in Greece is equal to 0.66% when the yield differential is below 2.13%, but beyond this thresh-

old level, the sensitivity of import prices becomes higher and reaches full ERPT. Our findings raise the serious question of

whether the exchange rate could be an effective tool to boost the trade balance and prevent deflationary threats when financial

crisis hits. Copyright © 2015 John Wiley & Sons, Ltd.

Received 14 July 2015; Revised 22 September 2015; Accepted 6 October 2015

JEL CODE: C22; E31; F31

KEY WORDS: Exchange rate pass-through; import prices; sovereign spreads; smooth transition models

1. INTRODUCTION

The financial crisis of 2007–2008 had a serious impact on the Euro area government bond market and turned into a

sovereign debt crisis at the beginning of 2010. Due to the general weakness of fiscal fundamentals in the so-called

GIIPS countries, that is, Greece, Italy, Ireland, Portugal and Spain, financial markets were highly affected by

deeply felt concerns on the solvency of this group of countries. There was a change in the markets’assessment

of sovereign debt risks. This caused yield spreads to German bonds to rebound to levels exceeding those observed

in the early years of the third stage of the Economic and Monetary Union (EMU). As a matter of fact, the introduc-

tion of the single currency in 1999 eliminated normal market reactions towards highly indebted Euro area coun-

tries; there was a phase of pronounced government bond yield convergence, as the Euro was regarded as a safe

haven (Figure 1). Additionally, the improvement in the general macroeconomic environment brought about by

the monetary union changed the general perception of risk towards euro area (EA) economies with high debt ratios,

significantly narrowing interest rate differentials.

In this paper, we test whether this change in macroeconomic conditions, caused by the crisis of confidence on

sovereign debt, could influence the extent of exchange rate pass-through (ERPT). The exporter’s decision on the

extent to which exchange rate movements should be passed through into prices may depend on the perceptions

of the importing country’s macroeconomic stability. When the economy faces a financial or confidence crisis,

*Correspondence to: Christophe Rault, Department of Economics, University of Orléans, Orléans, France.

E-mail: chrault@hotmail.com; web-site: http://chrault3.free.fr/

Copyright © 2015 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 154–166 (2016)

Published online 11 November 2015 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1539