«Floating with a Load of FX Debt? by Tatsiana Kliatskova and Uffe Mikkelsen IMF Working Papers describe research in progress by the author(s) and are ...»
Floating with a Load of FX Debt?
by Tatsiana Kliatskova and Uffe Mikkelsen
IMF Working Papers describe research in progress by the author(s) and are published
to elicit comments and to encourage debate. The views expressed in IMF Working
Papers are those of the author(s) and do not necessarily represent the views of the IMF, its
Executive Board, or IMF management.
© 2015 International Monetary Fund WP/15/284
IMF Working Paper European Department Floating with a Load of FX Debt?
Prepared by Tatsiana Kliatskova and Uffe Mikkelsen Authorized for distribution by Antonio Spilimbergo December 2015 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
Abstract Countries with de jure floating exchange rate regimes are often reluctant to allow their currencies to float freely in practice. One reason why countries may wish to limit exchange rate volatility is potential negative balance sheet effects due to currency mismatches on the balance sheets of firms and households. In this paper, we show in a sample of 15 emerging market economies that countries with large foreign exchange (FX) debt in the non-financial private sector tend to react more strongly to exchange rate changes using both FX interventions and monetary policy. Thus, our results support the idea that an important source of “fear of floating” is balance sheet currency mismatches.
This effect is asymmetric; that is, countries stem depreciation but not appreciation pressure. Moreover, FX debt financed through the domestic banking system is more important for fear of floating than FX debt obtained directly from external sources.
JEL Classification Numbers: F31, F34, E58 Keywords: FX interventions, Monetary policy, Balance sheet effects, Exchange rates, Emerging markets Author’s E-Mail Address: TKliatskova@diw.de and UMikkelsen@imf.org 3
I. INTRODUCTIONMany emerging markets are reluctant to let their currencies float. Even when de jure they announce themselves as having a floating exchange rate regime, de facto they are not allowing their exchange rates to move freely. One explanation why countries may fear to let their exchange rates float is a negative influence of exchange rate volatility on corporate and/or household balance sheets. When they borrow in foreign currency while receiving income in local currency, exchange rate depreciation may lead to a sharp rise in debt-service costs, bankruptcies, and disruption of investment and consumption demand. Corporate and household sector distress can further spill over to the financial sector generating deeper financial instability, in particular, if the foreign currency exposures have been financed by the domestic banking system. The issue of large foreign currency debt accumulation is especially important for emerging markets as they are usually less able to borrow abroad in their domestic currency than advanced economies. The problem is amplified by lack or high costs of hedging, especially for households and small and medium size firms. In addition, moral hazard could amplify the problem as households, companies, and banks that expect to be bailed out – directly by governments or indirectly by central bank policies aimed to curb depreciation pressures – do not internalize their risks and may borrow more in foreign currency.
There is a vast theoretical and empirical literature that focuses on whether and how countries react to movements in exchange rates. Calvo and Reinhart (2002) analyze the behavior of exchange rates, foreign exchange reserves, and interest rates across different exchange rate arrangements and find that countries that claim they are floating are often not. Many emerging market countries seem to be using interest rates and FX market interventions to stabilize exchange rates. Using domestic interest rates and FX interventions to stabilize exchange rates could be due of lack of credibility, high pass-through from exchange rates to prices, or negative balance sheet effects from exchange rate movements. The last channel is the focus of this paper.
In our paper we assess whether countries with high FX debt of non-financial firms and households tend to react more strongly to changes in exchange rates assuming that the decision to borrow in FX is exogenous. We rely on a set of 15 emerging market countries1 using monthly data for 2002-15. We look at two instruments that can be used to manage exchange rates – adjustment of policy rates and FX interventions using central bank FX reserves – and analyze whether the level of FX debt affects the sensitivity of these instruments to changes in exchange rates.
The paper relates to literature that explores the effect of the currency denomination of debt on exchange rate behavior. Liability dollarization is considered to be one of the factors that cause central banks to care about exchange rate stability. Hausmann, Panizza and Stein (2000), Harms and Hoffmann (2011) and Honig (2005) among others show that liability 1 The countries in our sample are: Brazil, Chile, Colombia, Georgia, Hungary, Indonesia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, and Turkey.
4 dollarization plays a central role in producing fear of floating. The first two papers use the choice of exchange rate regime as a dependent variable and Honig (2005) explores the influence of the ability to borrow internationally in local currency on exchange rate volatility relative to the volatility of policy instruments. Devereux and Lane (2003) suggest that for developing economies bilateral exchange rate volatility is strongly negatively affected by the stock of external debt, while for industrial countries external debt is not significant in explaining exchange rate movements. In this paper, however, we take exchange rate behavior as given and focus on central bank policies.
Our paper is also closely related to a number of empirical and theoretical studies on the use of different policy instruments to stabilize exchange rates. For this purpose central banks can use monetary policy rates and FX interventions as well as less conventional instruments such as capital controls or exchange rate-linked instruments. Benes et al. (2011) gives theoretical justifications for including sterilized interventions as an additional central bank instrument alongside the Taylor rule and find that there can be advantages for combining inflation targeting with some degree of exchange rate management. Mohanty and Klau (2004), Filosa (2001), Roger, Restrepo, and Garcia (2009), among others, claim that central banks strongly respond to exchange rate movements. Roger, Restrepo, and Garcia (2009) argue that for financially-vulnerable emerging market economies, some exchange rate smoothing is beneficial, largely reflecting perverse effects of demand shocks on exchange rate movements.
Adler et al. (2015), Blanchard et al. (2015), Adler and Tovar (2011), etc. suggest that (sterilized) FX interventions are effective in affecting exchange rates. The effectiveness depends on the depth of the financial market (Adler et al., 2015) and it decreases rapidly with the degree of capital account openness (Adler and Tovar, 2011). In our paper we look at how policies (policy rates and FX interventions) react to exchange rate changes allowing the variation of responses to differ with non-financial private sector FX debt.
Other literature focuses on how exchange regime choice and central bank policies may influence agents’ borrowing behavior. Arteta (2003) suggests that floating exchange rate regimes exacerbate currency mismatches in domestic financial intermediation as those regimes seem to encourage deposit dollarization more strongly than they encourage matching via credit dollarization. On the contrary, Kamil (2012), using firm level data, finds that after countries switch from pegged to floating exchange rate regimes, firms decrease their levels of foreign currency exposures by reducing the share of debt contracted in foreign currency and matching more systematically their foreign currency liabilities with assets denominated in foreign currency and export revenues. Two-way causality is addressed by Chang and Velasco (2006) and Chamon and Hausmann (2005). In Chang and Velasco (2006) residents choose in which currency to borrow and the central bank, in turn, chooses exchange rate regime. Fear of floating emerges endogenously and in association with a currency mismatch in assets and liabilities. At the same time, the choice of currency to borrow in depends on the residents’ expectations regarding the central bank’s policy. Both fixed and floating exchange rate regimes can be equilibrium, while the latter is Pareto-efficient. Empirically, Berkmen and Cavallo (2009) confirm that countries with high liability dollarization (external, public, or financial) tend to be more actively involved in exchange rate stabilization operations.
However, their results suggest that there is no evidence that floating, by itself, promotes dedollarization. Throughout the paper, we treat FX debt as exogenous and do not directly 5 account for potential endogeneity of FX debt. However, we discuss why we believe the results should be robust to potential endogeneity of FX debt.
Our paper contributes to the existing literature in a number of dimensions. First, we focus on the influence of private sector FX exposures and account directly for externally and domestically financed FX borrowing, whereas most papers look either at banks’ liability dollarization or the total FX debt of the country. This allows us to reach specific conclusions about which forms of FX debt matter more for the use of FX interventions and monetary policy rates and draw relevant policy conclusions from our findings. Second, we distinguish between the effects of appreciation and depreciation of exchange rates assuming that currency depreciation may threaten financial stability due to balance sheet effects while currency appreciation may negatively influence export performance.
Our findings suggest that countries with large FX debt in the non-financial private sector tend to react more strongly to exchange rate changes using both FX interventions and monetary policy rates. The results are driven mainly by reactions to depreciation of exchange rates and we find that FX debt in the non-financial private sector from domestic sources is a more important driver of central bank policies than the debt obtained directly from abroad. The importance of FX debt in inhibiting central banks from allowing exchange rates to move freely implies that monetary policy could be overburdened by multiple goals. Policies should focus on limiting FX lending by the domestic banking system to ensure that monetary policy can work effectively.
The rest of the paper is organized as follows: In section II, we present the data and stylized facts about FX exposures, section III discusses empirical methodology, section IV presents our main results, in section V we perform a number of robustness checks and extensions, and section VI concludes.
II. STYLIZED FACTS ABOUT FX EXPOSURES
While balance sheet currency mismatches may appear in all sectors, in this paper we focus on the non-financial private sector (households and non-financial companies). Outright net open FX positions in the financial sector and government FX exposure are thus excluded. Banks in floating exchange rate regimes are likely to either keep a balance between their FX assets and liabilities or at least hedge on-balance sheet open positions through off-balance sheet operations. Government FX exposure, while being important for the public sector risk, is assumed not to be taken into account by the monetary authority as this can less easily be justified within a typical central bank mandate of maintaining price and financial stability.
However, as section V shows, the results are robust if the scope is broadened to include the FX debt of banks and government.
We consider two sources of FX exposure of the non-financial private sector. The first is the borrowing directly from abroad, which we obtain from external debt statistics. The second is the FX lending from the financial sector – funded mainly through banks' borrowing abroad (in FX) as intermediaries of capital inflows or from accepting local FX deposits (deposit dollarization). We obtain this data from the IMF Monetary and Financial Statistics.
6 Our sample includes 15 emerging market countries with floating exchange rates.2 We use monthly data for the period 2002-15 (subject to data availability). A full description of the variables and data sources as well as summary statistics is presented in the Appendix.