Exchange rate driven balance sheet effect and capital flows to emerging market economies

Abstract

Depreciation of the local currency may deteriorate corporate balance sheets with currency mismatch. This risk might in turn spill over onto creditors, potentially affecting the financial health of banks. In a set of 26 emerging market economies, we find that this channel adversely affects the access of domestic banks to international bank lending when global liquidity tightens. The countercyclical value of US Dollar (USD) over global financial cycles amplifies the valuation effect of USD denominated liabilities. We exploit this variation and find that, when global liquidity tightens, banking sectors in countries whose foreign currency liabilities have a larger share of USD experience more contraction in cross-border bank loans. As the results imply a strong exchange rate driven balance sheet effect, the implementation of foreign currency related macro prudential policies during periods of abundant global liquidity should strengthen the financial stability of the banking system. On the other hand, exchange rate led balance sheet effect does not seem to significantly influence cross-border bank loans to firms with direct access to international bank lending.