Abstract
More than 20 years after the Asian financial crisis, the region’s continued high reliance on United States (US) dollar-denominated funding has significant implications for the transmission of global financial conditions to domestic financial and macroeconomic circumstances. Given limited domestic capital market-based financing solutions, a high reliance on funding denominated in US dollars renders countries vulnerable to changing global financial and liquidity conditions. Using a dynamic panel and a vector autoregression model to assess the exchange rate as a possible transmission channel, we find that changes in bilateral US dollar exchange rates can have a significant impact on sovereign credit risk. In particular, a depreciation of the domestic currency against the US dollar leads to a widening of the sovereign bond spread. This finding suggests a significant relationship between US dollar funding exposure, US dollar liquidity conditions, and domestic financial conditions in some emerging Asian economies, and thus highlights one source of structural vulnerability. Given that the magnitude of the effects varies across countries, policy makers need to monitor closely the interplay between the exchange rates and local financial market conditions with tailored prescriptions for domestic financial resilience.
Highlights
Our results suggest that changes in the bilateral exchange rate against the United States (US) dollar affect the risk-taking behavior of foreign investors, highlighting the important role global dollar funding conditions play on domestic financial conditions
Our results suggesting that an appreciation in the bilateral exchange rate against the US dollar improves the domestic financial condition for emerging Asian economies (EAEs), while we find the presence of financial and trade channels of the exchange rate working in opposite directions
Building upon existing literature and accounting for emerging economies’ heavy reliance on US dollar funding, we examine the impact of changes in the bilateral exchange rate against the US dollar on local financial conditions for eight Asian economies and check for a feedback effect from sovereign bond spreads
Summary
The difficulties emerging market economies have faced in borrowing internationally in their domestic currencies are well-documented and are collectively referred to as the “Original Sin” phenomenon, a term coined by Eichengreen, Hausmann, and Panizza (2005), and referred to in a number of studies (Reinhart, Rogoff, and Savastano 2003; Eichengreen and Hausmann 2005; Lane and Shambaugh 2010). The global banks, in turn, finance their cross-border lending by tapping US dollar money market funds from financial centers As another example, Rey (2013, 2016) suggests that monetary policy shocks from advanced economies could spill over into financial conditions in other places, even under a floating exchange rate regime. Our results suggest that changes in the bilateral exchange rate against the US dollar affect the risk-taking behavior of foreign investors, highlighting the important role global dollar funding conditions play on domestic financial conditions To this end, we identify two competing effects through which the exchange rate influences financial conditions in emerging markets: (i) the trade channel, which tends to loosen domestic financial conditions by improving external competitiveness; and (ii) the financial channel, which tends to tighten domestic financial conditions by worsening the economy’s balance sheet.
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