Debt thresholds and real exchange rates: An emerging markets perspective

In this paper we empirically analyze nonlinearities in short-run real exchange rate dynamics. Our findings suggest that real exchange rate misalignments are considerably less persistent and more volatile during times of high debt. Assessing the variance of changes in misalignments, we retrieve evidence indicating that the nominal exchange rate and inflation differentials are more important determinants in states of high debt than in states of low debt. Overall, our results imply that nonlinearities have non-negligible implications for the mechanics of real exchange rate adjustment in emerging markets.