Currency Mismatches Research Articles

Financial crises, bailouts and monetary policy in open economies

I jointly study the optimal bailout policy and monetary policy in open economies that borrow in foreign currency from international lenders. A policy dilemma emerges during financial crises. Policymakers trade off the benefit of more bailouts alleviating firms’ financial constraints against the cost of larger currency devaluation, which tightens firms’ financial constraints. I embed the optimal bailout in an otherwise standard “sudden stop” model with nominal rigidities. The model sheds light on the role of bailouts and currency mismatch in driving the exchange rate dynamics, firms’ balance sheets and economic recovery. Quantitatively, the model matches key business cycle moments. A welfare evaluation shows that there are in general welfare gains from the systemic bailout policy despite ex ante moral hazard problems of firms.

Private sector participation in infrastructure in emerging market and developing economies: Evolution, constraints, and policies

AbstractThe private sector can play important roles in closing the infrastructure investment gaps in emerging market and developing economies. However, private participation in emerging market and developing economies' infrastructure has declined over the past decade, reflecting persistent structural challenges and risks in the business environment. The decline was broad‐based and gained momentum following the 2013 taper tantrum and the end of the commodity super cycle. Incentivizing greater private sector participation in infrastructure will require policies to improve access to long‐term finance and to derisk the business environment. This will require efforts to strengthen the banking sector regulation and supervision, to improve the legal and contractual environment, and to limit information asymmetries. Deepening local financial and bond markets can make it possible for infrastructure bonds to be issued in local currencies and minimize potential currency mismatches. Improvements in the broader business environment can benefit from greater macroeconomic stability and stronger institutional frameworks. Policies that improve the quality of projects at entry, address currency risk, relax capital controls, and enable cost recovery pricing can unlock private sector participation in infrastructure financing. Strong government support, including ensuring regulatory quality, and providing well‐targeted guarantees and subsidies, can play a critical role.

DOMESTIC ORIGINAL SIN OF SOVEREIGN DEBT IN TÜRKİYE

The study analyzes the original sin of sovereign debt in Türkiye with a focus on domestic original sin. Eichengreen and Hausmann (1999) define original sin as the inability of a country to borrow in its own currency in the international market, while the issuance of foreign currency debt in the domestic market is defined as domestic original sin (Eichengreen, Hausmann, and Panizza, 2003). In this context, the structure of the debt portfolio was evaluated based on the indicators developed by Eichengreen, et al. (2003) and its simplified version widely used in the literature. Based on the analysis of the sovereign debt portfolio, it has been concluded that although the debt stock to GDP ratio is relatively low in Türkiye, the domestic original sin has reached historically high levels and currency mismatch is significant.

Dollar Safety and the Global Financial Cycle

Abstract We develop a model of the global financial cycle with one key ingredient: the international demand for safe dollar assets. The model matches patterns of dollar borrowing and currency mismatch, the U.S. external balance sheet, exorbitant privilege, spillovers of the U.S. monetary policy to the rest of the world, and the dollar as a global risk factor. In doing so, we lay out a novel transmission mechanism through which the U.S. monetary policy affects the currency market and the global economy. The global financial cycle is a dollar cycle.

Original sin redux and deviations from covered interest parity

Emerging markets (EMs) have increasingly turned to international capital borrowing in their local currencies (LC), leading to considerable LC external debts, particularly after the 2007 global financial crisis. Our study shows that this rise in LC external debts results in more significant deviations from the covered interest rate parity (CIP) between EMs and the US. This phenomenon is primarily attributed to a shift of currency mismatch risk and specific transaction costs from EM borrowers to international investors. As a result, EMs encounter elevated funding costs in comparison to the US, since investors seek higher returns to offset the added risks and expenses linked to LC external debts. Our analysis further underscores that the influence of LC external debts on amplifying CIP deviations is especially notable in EMs marked by substantial currency mismatch risks, such as those with floating exchange rate systems, heightened inflation risks, and significant currency depreciations. Moreover, the presence of stringent capital controls and limited debt market liquidity, which signify high transaction costs, intensify these effects.

Challenges in promoting local currency corporate bonds in Asia: Evidence from international business relationships

In Asia, in contrast to government bond markets where reliance on foreign currency bonds has diminished after proactive policy initiatives, the corporate sector still has a large share of foreign currency bond outstanding. We analyse this phenomenon by examining the driving factors behind Asian corporate bonds’ currency choice (local currencies versus US dollar). Our results suggest that, although the successful market developments reduced barriers for Asian firms to issue in local currencies, such constructive effect was inevitably limited by firms’ FX exposures induced by Asian firms’ rapid involvement in international business during the same period. In addition, US dollar bond issuances in the region are more associated with FX funding needs from the expenditure side rather than natural hedging against FX revenue, implying that the problem of currency mismatch likely still exist among Asian firms. As such, Asian policymakers should devote more attention to firms with more cross-border payments when scrutinising the corporate sector’s financial vulnerability. They should also continue fostering the development of local currency bond markets and spur the use of local currencies in invoicing regional business transactions.

Dampening Global Financial Shocks: Can Macroprudential Regulation Help (More than Capital Controls)?

AbstractWe show that macroprudential regulation significantly dampens the impact of global financial shocks on emerging markets. Specifically, a tighter level of regulation reduces the sensitivity of GDP growth to capital flow shocks and movements in the Chicago Board Options Exchange's VIX. A broad set of macroprudential tools contributes to this result, including measures targeting bank capital and liquidity, foreign currency mismatches, and risky credit. We also find that tighter macroprudential regulation allows monetary policy to respond more countercyclically to global financial shocks. This could be an important channel through which macroprudential regulation enhances macro‐economic stability. We do not find evidence that capital controls provide similar benefits.

Overcoming ‘original sin’ to secure policy space

AbstractMore than two decades after the emerging market crises of the 1990s, foreign investors are now active investors in emerging-market local-currency-denominated sovereign bonds. In this sense, emerging market governments have overcome ‘Original Sin’—the dictum that emerging market borrowers cannot borrow from foreigners in their own currency. However, although the borrowers no longer bear the risk of currency mismatches, the mismatch has migrated to the lenders’ balance sheet in the sense that investors evaluate gains and losses in terms of dollars or other major currencies. This paper examines the associated risks and potential remedies to financial stability risks stemming from this migration of currency mismatch from the borrower to the lender.

Exchange rate risk, banks' currency mismatches, and credit supply

We exploit the post-Brexit depreciation of the British pound as an exogenous shock to show how exchange rate shocks transmit to the German real economy through the banking sector. German banks with GBP currency mismatches (between assets and liabilities, including off-balance sheet items) suffer losses when the currency of assets depreciates relative to that of liabilities, which they internalize by cutting back credit supply. For a one percentage-point loss in equity, a bank cuts credit supply by 73 basis points on average, with stronger effects for banks with lower equity capital. The credit contraction of German banks (i) affects also firms that are not directly related to UK conditions, (ii) holds across all industries, including non-tradable sectors, (iii) impacts relatively more small borrowers, and (iv) decreases affected firms' investments.

Optimal monetary policy under currency mismatches in imperfect financial market

There is a large body of evidence documenting that many emerging market economies are subject to external financial shocks. We propose a two-country Dynamic General Equilibrium Model(DSGE) with three market imperfections: currency mismatches, moral hazard in banking and dominant currency pricing. Building upon Aoki, Benigno and Kiyotaki (2020) and Akinci, Queralto (2020), we analyze the optimal monetary policy in response to foreign interest rate shocks under the presence of the frictions. The results show that foreign monetary policy tightening leads to sharper local currency depreciation when import and export prices are set in the dominant currency compared to producer currency pricing. The optimal policy response to the foreign interest rate hike is a foreign exchange (FX) intervention with relatively strict inflation targeting. Macroprudential measures offer a modest macroeconomic and financial stabilization effect. We also conclude that domestically-produced goods inflation targeting alone is the worst monetary approach in EMs that attribute several real economy and financial imperfections. Nevertheless, allowing for integration of different monetary tools as well as introduction of FX hedging would be an interesting extension of our analysis.

Yet it Endures: The Persistence of Original Sin

Notwithstanding announcements of progress, “international original sin” (the denomination of external debt in foreign currency) remains a persistent phenomenon in emerging markets. Although some middle-income countries have succeeded in developing markets in local-currency sovereign debt and attracting foreign investors, they continue to hedge their currency exposures through transactions with local pension funds and other resident investors. The result is to shift the locus of currency mismatches within emerging economies but not to eliminate them. Other countries have limited original sin by limiting external borrowing, passing up valuable investment opportunities in pursuit of stability. We document these trends, analyzing regional and global aggregates and national case studies. Our conclusion is that there remains a case for an international initiative to address currency risk in low- and middle-income economies so they can more fully exploit economic development opportunities.

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

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.

Foreign participation in local currency government bond markets in emerging Asia: Benefits and pitfalls to market stability

With the objective of reducing the problem of currency mismatch, emerging Asian economies have made a concerted effort to develop the local currency government bond (LCGB) markets since the early 2000s. Since then, foreign investors have had a substantial and growing presence in the markets. This paper examines the effects of foreign participation in the LCGB markets on the yield spread. We show that the effect of high foreign participation on market stability is non-monotonic: During tranquil periods, high foreign participation helps reduce yield spread; however, in times of market distress, high foreign participation asymmetrically exacerbates the widening of the yield spread by a larger magnitude. This effect could be due to foreign investors' concerns about currency risk. This is supported by the estimation that yield spread widening during market distress is mainly driven by the currency risk component, but not the credit risk component. Our results underscore the importance of broadening the domestic investor base in the region, and maintaining a manageable exchange rate expectation and central bank credibility.

External Balance Sheets and the COVID-19 Crisis

At the onset of the COVID-19 economic crisis, as in other crisis episodes, we observed a rapid appreciation of “safe haven” currencies. We quantify currency-induced balance sheet valuation effects for aggregate external positions as well as for broadly defined asset classes for the first quarter and the full year 2020. To do so, we use new data on the currency composition of cross-border assets and liabilities for 46 countries. In contrast with past financial crises, many emerging markets did not experience losses on their aggregate external balance sheets despite facing a domestic currency depreciation. This was partly due to currency-induced valuation gains on equity positions offsetting losses on debt positions, and partly due to reduced currency mismatch on their external debt positions. We conduct the stock-flow reconciliation of net international investment positions to measure overall valuation effects and compute the proportion that is due to changes in currency values. For about half of the countries in our sample, currency-induced valuation effects were substantial, representing over 50 percent of total valuation effects in 2020Q1 and the full year 2020.

Review of The Institutional View on The Liberalization and Management of Capital Flows — Background Note on Assessing Systemic Financial Stability Risks Due to FX Mismatches

This note outlines the approach of the proposed revision to the Institutional View (IV) when assessing whether systemic financial stability risks are elevated due to foreign currency (FX) mismatches. The approach builds on the staff guidance regarding risk assessments in bilateral surveillance, while allowing for flexibility to draw on future advances in best practice. This note proposes a two-step approach to assess systemic risks from FX mismatches. This note is organized as follows. Section II outlines the sources of systemic risks stemming from FX debt and potential amplification channels. Section III outlines the risk assessment approach in practice and Section IV concludes.

Devaluations, Deposit Dollarization, and Household Heterogeneity

We study the aggregate and re-distributive effects of currency devaluations in a small open economy heterogeneous households model with leverage-constrained banks. Our framework captures three stylized facts about liability dollarization in emerging economies: i) banks and firms borrow in foreign currency; ii) households save in dollar-denominated local bank deposits; and iii) such deposits are mainly held by wealthier households. The resulting currency mismatch causes an erosion of banks' net worth during a devaluation, depressing credit supply. The ensuing macroeconomic downturn is amplified by a strong reduction of consumption among poorer households in response to rising borrowing costs and falling labor income. Richer households are partially insured, as they are holding a larger share of their wealth in foreign currency denominated assets. We show that a larger currency hedging by wealthier households deepens the recession and amplifies the negative spillovers for poorer agents. When deposit dollarization is high, welfare gains can arise if monetary policy dampens a depreciation.

Currency Mismatches and Public Debt Management: What is Effective Strategy for Developing Country?

Developing countries are often confronted with debt problems because of the risks of over-indebtedness and especially the heavy default history. In such a context, debt management must be rigorous and guarantee a stable debt. However, such management is difficult in an environment marked by liabilities denominated in foreign currencies and assets denominated in domestic currencies, i.e., an environment of currency mismatches. The objective of this paper is then to determine, from a partial equilibrium model, an effective strategy for managing public debt in the presence of currency mismatches. We conclude that it is preferable to arbitrate between a debt denominated in foreign currency and a debt denominated in domestic currency. We also find that this arbitation depends on the financing conditions, i.e. the domestic interest rate and the risk premium on foreign debt. More precisely, when the government's objective is to minimize the interest burden, it is preferable to issue more local currency debt and less foreign currency debt, as long as the domestic interest rate is lower than the risk premium on foreign debt.

Sovereign Risk, Currency Risk, and Corporate Balance Sheets

AbstractWe provide a comprehensive account of the evolution of the currency composition of sovereign and corporate external borrowing by emerging markets from 2003 to 2017. We show that a higher reliance on foreign currency debt by the corporate sector is associated with higher sovereign default risk. We introduce local currency sovereign debt and private sector currency mismatch into a standard sovereign debt model to examine how the currency composition of corporate borrowing affects the sovereign’s incentive to inflate or default. A calibration of the model generates the empirical patterns of sovereign credit risk.

Determinants of Financial Instability in Selected <i>East and Southern African</i> Countries

These studies intend to identify the major determinants of financial instability in the East and Southern African Countries from 2010 to 2019. The issue of financial instability has, for long, been the major concern of policy makers, but still, there have been on-going debates and extensive discussions on measuring the financial instability. Several studies show that limits on LTV and DTI ratios can curb the feedback loop between mortgage credit availability and house price appreciation. Nevertheless, there is to date only every limited analysis of any macroeconomic effects and the use of macroprudential tools and no macro prudential instruments in East and Southern African Countries in general. Study used Credit growth and PCA analysis of financial stability index and system GMM model to identify financial instability in contemporary inclusive financial economy. FII constructed based on PCA of different variables like bank Z-Score and net interest margin in the first scenarios and using composite index of Credit growth, banking Score and net interest margin in the second scenarios. Result of the study reveals FII affected by Money supply, debt growth, inflation rate and economic growth etc. In spite of the credible theoretical arguments, using the system GMM method study found that FII negatively affected by Money supplies, debt growth, inflation rate, volatility of economic growth in 14 East and Southern African Countries included in the study between 2010 and 2019. Therefore, building integrated, coordinated and potentially consistent macro prudential policies was required to avoid negative spillovers that could counteract the financial instability. Furthermore, to constrain funding or liquidity risks, liquidity-related instruments like limits on net open currency positions, currency mismatches and reserve requirements are an asset.

Procjena profitabilnosti banke u evroizovanim ekonomijama

Financial euroization is a significant phenomenon in developing countries. The key financial institutions for macroeconomic stability in these countries are the banks. Conversion of most of the financial assets and liabilities into foreign currency creates a currency mismatch between the assets and liabilities in domestic and foreign currency. Banks in the role of intermediaries between depositors and borrowers face the risks of accepting foreign currency deposits and placing foreign currency loans. With this, financial euroization can impact the performance of banks. The paper's main objective is to analyze the impacts of euroization on the performance of banks in North Macedonia, Serbia, and Bosnia and Herzegovina for the period from 2010 to 2020. For performance measure, we use bank profitability. The paper uses a pre-set empirical model, in which the dependent variable is ROA (annual data for the return on assets - as a variable for measuring the profitability of banks) and a set of independent variables, including the degree of euroization. The results suggest that the model is robust, and the variables are statistically significant. In conclusion, this outcome can be ascribed to the segmentation of the bank credit portfolio in credit denominated in domestic versus foreign currency credit denomination. Moreover, the degree of euroization proved to be statistically significant for predicting the performance of banks, hence is high bank management decision-making information.