Non-Linear Effects of REER Misalignment on Banking Stability: New Evidence from Emerging Countries

This paper examines the impact of real effective exchange rate (REER) misalignment on banking stability, while emphasizing the moderating effect of institutional quality. We also aim to investigate the non-linearity of this relationship. Based on a panel of 40 emerging countries covering the period from 2000 to 2020, and using the system generalized method of moments (SGMM) estimator, we show that REER misalignment positively impacts banking stability. A second set of estimations provides a more nuanced view. The results reveal that overvaluation contributes to enhance banking stability, while undervaluation proves to be a source of instability. The results also suggest that institutional development boosts both the positive and negative effects. Further investigations show that the considered relationship is conditional on the magnitude of the exchange rate misalignment and on the level of banking stability. The empirical results reveal the existence of an inverted U-shaped relationship between REER misalignment and banking stability: low levels of exchange rate misalignment contribute to boost stability, while high levels of misalignment exacerbate instability. In addition, REER misalignment promotes stability during calm periods, while it contributes to fuel instability during financial turmoil. Misalignment thus proves to be a double-edged weapon, which should be used with great caution to avoid systemic crisis.