Foreign currency debt and the optimal monetary policy response to rising US interest rates

ABSTRACT

Rising US interest rates impact emerging economies through capital outflows and currency depreciations. For those with flexible exchange rates, the appropriate monetary policy response weighs the traditional competitiveness effect with a balance sheet effect created by the presence of foreign currency denominated debt (liability dollarization). This paper presents a basic Keynesian macro model that incorporates this balance sheet effect and demonstrates that it significantly complicates the monetary policy response to depreciations. Without full knowledge of the size of these competing effects, the central bank can make large mistakes in setting interest rates.

KEYWORDS:

• Liability dollarization
• exogenous depreciations
• US monetary policy spillovers
• optimal monetary policy

JEL CLASSIFICATION:

• E58
• F42

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ A rise in foreign interest rates could also affect domestic output through other channels as well, such as a contraction in international lending that leads to a fall in domestic investment (Cetorelli and Goldberg 2012; Miranda-Agrippino and Rey 2015). The focus of this paper, however, is on the liability dollarization channel. There is a growing empirical literature testing the relevance of these balance sheet effects. For example, Aguiar (2005) finds that Mexican firms with heavy exposure to short-term foreign currency debt before the 1994 devaluation experienced relatively low levels of post-devaluation investment. Specifically, observed foreign currency debt exposure reduced net investment rates for 1995 from positive 1% to negative 3.6% following the December 1994 depreciation. Furthermore, annual GDP growth was 4.5% for 1994 and −6.2% in 1995. Thus, the effects of depreciations can impact investment and output soon after the depreciation occurs. Bebczuk, Arturo., and Panizza (2006) present macro evidence of this effect using a large sample of countries during the period 1976–2003, finding that the presence of liability dollarization weakens the expansionary effect through the standard trade channel. Specifically, in countries with low levels of liability dollarization, a 20% depreciation is associated with a 0.5 percentage point increase in the growth rate of GDP per capita the following year. However, in countries with significant dollar liabilities, including most of their developing country sample, devaluations are in fact contractionary.

² Bacchetta (2000) also argues that liability dollarization leads to both ambiguous initial effects of depreciation on output and at the same time affects the monetary policy response because of the competing competitiveness and balance sheet effects. The results in this paper, however, imply additional complications, as mentioned above and discussed in the rest of the paper.

³ This abstracts from issues related to the zero lower bound as well as the difficulty exchange rate adjustment can have in insulating an economy from the global financial cycle (Rey 2014).

⁴ The setup of the model follows Honig (2012).

⁵ While I do not model a public sector with foreign currency debt (the debt here is held by domestic firms and households), government spending could also be impacted by currency depreciations as governments may have to run larger budget surpluses when foreign currency debt rises in value following a depreciation. This would strengthen the balance sheet effect. The threshold for the amount of foreign currency debt at which depreciations become contractionary is therefore a relative threshold, not an absolute threshold. For countries with small export sectors, depreciations become contractionary at lower levels of foreign currency debt. As discussed above, empirical evidence suggests that this threshold exists (Bebczuk, Arturo., and Panizza 2006).

⁶ There are a number of factors that could limit the contractionary effects of depreciation even under significant liability dollarization: sufficient fiscal space to provide support to the economy, IMF loans, and a well-capitalized financial system that can withstand a deterioration in net worth. In addition, not only does a large export sector support the economy through the competitiveness effect, exporters are also more likely to earn revenue in dollars and thus do not suffer from currency mismatches even if they have borrowed in dollars. For both reasons, a strong export sector works to limit the contraction following a depreciation.

⁷ The interest rate changes in Regions 1 and 3 are consisted with empirical evidence that emerging economies respond to a rise in US interest rates with interest rate hikes of their own, even those with flexible exchange rates (Bhattarai, Chatterjee, and Park 2017).