«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 ...»
Such reaction might be optimal given the negative implications for financial stability from excessive exchange rate movements in countries with large FX exposures. However, our findings do not allow us to corroborate optimality. Other factors such as pressure on central banks to protect important sectors in the economy (and possibly large financial and nonfinancial firms and households) where FX indebtedness is high could also be at work. One should therefore be careful about drawing policy conclusion based on the assumption that the observed policies reflect optimal monetary policy. However, theoretical literature supports that when foreign currency balance sheet mismatches are large, some exchange rate management may be the optimal central bank policy (while not necessarily a Pareto efficient equilibrium).
When the FX exposure of the non-financial private sector is high, policies to reduce it should be considered to ensure monetary policy can work effectively. 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. Our finding that FX debt financed from the domestic banking system seems to be more important suggests that policies should focus first and mainly on limiting the FX lending by the banking system. Such policies could include strengthening of supervision of FX lending by the domestic banking sector, prohibiting banks to take too large outright currency risks, higher reserve requirements for foreign currency funding, higher capital requirements and risk-weights on FX lending, and potentially outright quantity restrictions on banks’ borrowing in foreign currency. More generalized capital flow management policies – while likely effective in reducing the overall FX exposures – would be less targeted and, thus, less effective in specifically reducing the banking system FX lending.
Our analysis is based on macro level data. A highly relevant alternative approach would be to estimate the level of stress in the financial and non-financial system from exchange rate movements by using household and firm level data on FX assets, liabilities, hedging, and income. However, such micro level data is difficult to obtain on a consistent basis for several countries. More granular data from credit registries or surveys may allow for further research to shed light on the importance of foreign currency balance sheet exposures.
whether countries with high levels of balance sheet FX exposures are more likely to choose a fixed exchange rate regime.
Finally, while we treat the decision of households and firms to borrow in FX as purely exogenous, policies to limit exchange rates movements (depreciations mainly) may incentivize increased FX borrowing as explained by Chang and Velasco (2006). Emerging market countries may be diverging towards different equilibria with some on a suboptimal path of high and increasing FX borrowing and more exchange rate management, and others on a path of low and declining FX borrowing and less exchange rate management. Studying this dual causality empirically would also be an interesting (yet challenging) extension.
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FCL agreement dummy -0.002*** -0.002*** (0.001) (0.001) Observations 1,897 1,897 1,407 1,407 1,897 1,897 R-squared 0.960 0.960 0.941 0.941 0.960 0.960 Robust standard errors in parentheses, *** p0.01, ** p0.05, * p0.1