Financial contagion, interest rates and the role of the exchange rate as shock absorber in Central and Eastern Europe

This paper studies the impact of external factors on daily exchange rates and short-term interest rates in the Czech Republic, Hungary and Poland during the period August 1997 – May 2001. I find that neither exchange rates nor interest rates are influenced by short-term German interest rates. Nevertheless, I show that shocks to emerging-market risk premia had a significant impact on exchange rates in all three Central and Eastern European countries and on interest rates in the Czech Republic. In addition, studying the second moment of the variables, I demonstrate that Czech and Polish exchange rates were affected by ‘volatility contagion’ coming from emerging markets. I find also some partial support for the ‘volatility contagion’ hypothesis on Czech interest rates. These findings shed some doubts on the alleged theoretical ability of a floating exchange rate – such as in the Czech Republic – to absorb external shocks and insulate a country's domestic monetary policy completely. However, the spill-over effect on Czech interest rates might be explained by the ‘managed’ nature of the exchange rate regime, thereby re-establishing some credibility of the theory.