What currency strength means for sovereign creditworthiness

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USD weakening and the Taiwan dollar’s spectacular strengthening against the greenback in early May have had me thinking about currencies more than I usually do.

Following this month’s release of the Sovereign Stress Tracker covering 43 market-access emerging markets on Tellimer, this week I published more detailed results for the Europe and Central Asia region on that same platform.

One of the things that jumped out at me from the data is that, out of the ten countries covered, nine of them had experienced real exchange rate appreciation over the past three years. (As an aside: any guesses as to who the odd one out is? Hint: it’s the usual macro outlier. The answer is below.)

While the pandemic inflationary shock explains part of that real appreciation, that’s not the whole story.

There is also the fact that the U.S. dollar is weakening, which mostly correlates to nominal appreciation in trading-partner currencies, as seen most-prominently against the Taiwan dollar in early May 2025.

First, though, let’s back up, so I can explain a little about how the real exchange rate relates to sovereign risk.

Real exchange rates, or real effective exchange rates (i.e. the trade-weighted version versus all trading partner currencies), are merely nominal exchange rates adjusted for the ratio of domestic versus foreign prices.

Economists who model the probability of banking, currency, and sovereign debt crises in emerging markets typically use some variation of RERs or REERs as an independent variable.

In similar fashion, the IMF uses a three-year lagged REER change in its 1-2 year(s)-ahead sovereign stress probability model that I use in my own monitoring. It is part of the Fund’s Debt Sustainability Framework for Market-Access Countries, released in 2021.

Note that the model’s REER coefficient is positive, meaning that a rise in REER over three years is associated with a higher likelihood of sovereign stress, which includes default, significant spread widening, distressed debt exchanges, and other similar criteria.

A rising REER exacerbates sovereign risk because it reflects how an economy is becoming less competitive internationally on its export prices. The flip side of the coin is that imports are more competitive.

So the combined effect - all else equal - is a lower trade balance (e.g. a larger trade deficit), which can result in higher public and private debt, negative savings, higher unemployment, and/or lower tax revenues.

A rising REER usually also reflects rising inflation, as one of its two components, and inflation is very much the canary in the coal mine of sub-optimal economic policymaking.

This of course isn’t to say that nominal currency weakening isn’t without risks: it most certainly is for sovereign borrowers who have issued hard currency debt that they service with domestic currency-denominated revenues.

Currency appreciation can reflect a growth story…

Yet there is more nuance to the real exchange rate story depicted above.

The Balassa-Samuelson effect posits that rising productivity in tradable sectors (e.g. manufacturing) leads to higher wages in that sector, which in turn leads to higher wages in non-tradable sectors (e.g. haircuts at barbershops). The overall effect is one of real exchange rate appreciation.

Under this lens, REER appreciation reflects a positive trend of economic development and progress.

Similarly, if an economy starts experiencing strong growth, thanks to some sort of productivity-enhancing technological breakthrough, then international investors will pile into the country.

For this international investment to happen, they will need to sell their currency to buy the target country’s currency. All else equal, this will cause the target country’s currency to appreciate in nominal terms.

…but often REER appreciation reflects something worse.

Here’s the thing, though. If a currency appreciates nominally, all else equal this leads to lower imported inflation (i.e. the price of imports is now lower) and therefore lower overall inflation.

In other words, the nominal exchange rate generally works against inflation, i.e. they balance each other out to some extent. This means that strong undercurrents have to be at work to push the REER a lot in either direction.

So when the nominal exchange rate and inflation rise in tandem, i.e. the REER is rising, either it reflects productivity-enhanced growth or a macroeconomic imbalance. It is usually the latter.

If there are few-to-no productivity gains in tradables, while prices and wages in non-tradable service sectors are rising at a strong clip, a country could be on an unsustainable economic trajectory.

It might be that monetary policy is too loose (i.e. interest rates are too low) and/or that demand is stimulated via fiscal-monetary policies to an extent where it exceeds the economy’s supply potential.

Bad examples

All told, small REER changes reflect macroeconomic stability; large drops are a competitiveness gain; and large increases are a warning signal.

Returning to the Europe-Central Asia region, I look at Albania, Armenia, Azerbaijan, Bosnia & Herzegovina, Bulgaria, Georgia, Kazakhstan, North Macedonia, Russia, and Türkiye.

Türkiye bears the unfortunate distinction of having not only the largest REER increase in the region through April 2025, but also in the whole sample of 43 EMs.

This terrible result is due to Türkiye’s sky-high inflation, which hasn’t dropped below 36% since 2021. It’s most recent peak came in mid-2024, at around 75%.

You may note that the REER has only appreciated by 25 points over three years. Although this is the highest (and worst) number in the whole sample, it would be higher still if it hadn’t been for the lira taking a nosedive in recent years.

The REER alarm bell is also ringing loudly in Kazakhstan, having increased by 18 points over three years.

The real exchange rate dynamic is also a significant contributor to Kazakhstan’s sovereign risk profile.

While not as elevated as in Türkiye, inflation in Kazakhstan has also been an issue in recent years, peaking at around 21% in early 2023.

Like the lira, the tenge has also depreciated, albeit less spectacularly.

In sum, changes in REER serve as a useful warning signal for competitiveness, inflation, and macroeconomic stability.

Türkiye and Kazakhstan clearly share some characteristics in terms of maintaining price stability, which threatens sovereign creditworthiness.

As for the sole in-sample country in the region where the REER has dropped over three years? Why, that’s Russia. Of course.

Disclaimer: The content provided in this newsletter is for informational purposes only and should not be construed as financial, investment, or other professional advice. While I strive to ensure accuracy, I make no guarantees regarding the completeness or reliability of the information presented. Readers are encouraged to conduct their own research and consult with qualified financial professionals before making any investment decisions. The author and publisher are not responsible for any actions taken based on the information provided.