Foreign-currency exposures and the financial channel of exchange rates: Eroding monetary policy autonomy in small open economies?

Abstract

Foreign-currency exposures on an economy’s external balance sheet may jeopardise financial stability when the exchange rate depreciates. In fact, theory suggests that in such an environment it may be optimal for monetary policy in a floating regime to reduce exchange rate variation by mimicking foreign monetary policy in order to dampen financial cycles rather than focusing exclusively on stabilising the business cycle. We explore whether there is evidence in the data for monetary policy in small open economies facing such a trade-off between financial stability and macroeconomic stabilisation that gives rise to “fear-of-floating”. In a panel data set for 26 advanced and emerging small open economies with floating regimes for the time period from 2000 to 2017 we document evidence that is consistent with fear-of-floating, i.e. that small open economy monetary policy responds to base-country monetary policy even after controlling for macroeconomic fundamentals. We find that this fear-of-floating is particularly pronounced in the presence of foreign-currency exposures. Specifically, fear-of-floating is stronger when the foreign-currency exposures arise through debt rather than non-debt instruments, which is consistent with existing evidence documenting that these instruments are more fickle and sensitive to swings in investor sentiment. Moreover, the evidence for fear-of-floating is stronger when base-country monetary policy is tightened, suggesting that fear-of-floating typically arises in the face of immediate threats to financial stability due to depreciation pressures in the presence of foreign-currency exposures, rather than as preemptive action to mitigate the build-up of such vulnerabilities when the currency is appreciating.