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

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  • Kadırgan, Can

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.

Suggested Citation

  • Kadırgan, Can, 2023. "Exchange rate driven balance sheet effect and capital flows to emerging market economies," The Quarterly Review of Economics and Finance, Elsevier, vol. 87(C), pages 35-45.
    • Handle: RePEc:eee:quaeco:v:87:y:2023:i:c:p:35-45
    DOI: 10.1016/j.qref.2022.11.003
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    1. Kadırgan, Can & Özlü, Pınar, 2023. "Financial crisis, global liquidity and trade credit channel: Evidence from Türkiye," Emerging Markets Review, Elsevier, vol. 57(C).

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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