Currency devaluations, aggregate demand, and debt dynamics in economies with foreign currency liabilities

ABSTRACT

The article uses a post Kaleckian model to analyze how currency devaluations affect aggregate demand and capital accumulation in an economy with foreign currency liabilities in the short-run. In benchmark post Kaleckian open economy models, currency devaluations have two effects. First, they change international price competitiveness and thus affect net exports. Second, devaluations change income distribution and thereby affect consumption and investment demand. The overall effect on aggregate demand and investment is ambiguous and depends on parameter values. Existing models, however, disregard balance sheet effects that arise from foreign currency-denominated external debt. The article develops a novel post Kaleckian open economy model that introduces foreign currency-denominated external debt and balance sheet effects to examine the demand-effects of devaluations. Furthermore, the article models the dynamics of external and domestic corporate debt. It discusses how an economy may end up in a vicious cycle of foreign-currency indebtedness and derives the conditions under which indebtedness becomes stable or unstable. It shows that the existence of foreign currency-denominated debt means that contractionary devaluations are more likely, and that foreign interest rate hikes, and high illiquidity and risk premia compromise debt sustainability. Devaluations only stabilize debt ratios if they succeed in boosting domestic capital accumulation.

KEYWORDS:

• Balance sheet effects
• currency devaluation
• currency mismatch
• debt dynamics
• external debt
• Kaleckian model

JEL CLASSIFICATIONS:

• E11
• E12
• F36
• F41

Acknowledgements

I am indebted to Peter Skott, Eckhard Hein, Dany Lang, Marc Lavoie, Alexander Guschanski, Paul Auerbach, Yannis Dafermos, Antoine Godin, Annina Kaltenbrunner, Ewa Karwowski, Maria Nikolaidi, Engelbert Stockhammer, and two anonymous referees for invaluably helpful comments on different drafts of this paper. I am also grateful for helpful questions and suggestions by the participants of the Analytical Political Economy Workshop at UMass, Amherst on April 29, 2016, the 20th FMM Conference in Berlin on October 22, 2016, and the Kingston University Economics Department Research Seminar on February 1, 2017. All remaining errors are of course mine.

Notes

¹Currency mismatch occurs when assets and liabilities are denominated in different currencies.

²The MLC for unbalanced trade and a perfectly elastic supply of goods is given by$$\left(\frac{\mathrm{X}}{{\mathrm{e}}_{\mathrm{r}}\mathrm{M}}\right){\eta }_{\mathrm{x}}+{\eta }_{\mathrm{m}}>1$$, where η_x and η_m are the absolute values of the real exchange rate elasticities of exports and imports respectively, X is exports, e_r is the real exchange rate and imports is M. In case of a trade deficit, the ratio of exports to imports is smaller than unity. Thus, the MLC might not always be satisfied, especially in countries with strong trade deficits.

³Surveys of the contractionary devaluation debate are provided by Lizondo and Montiel (1989), and Bahmani-Oskooee and Mitzea (2003). Bahmani-Oskooee and Mitzea (2003) also review the empirical evidence and conclude that the effects of real depreciations on output and growth have turned out to be rather inconclusive and country-specific. A recent study (An, Kim, and Ren 2014) with 16 high and middle income countries also finds mixed results.

⁴I do not address the question whether a long-term undervaluation strategy is conducive to long-run growth. This is a separate topic that requires a different theoretical framework (see for example Razmi, Rapetti, and Skott 2012). Furthermore, the focus is restricted to small open economies whose domestic policies have no or negligible effects on the rest of the world—a plausible assumption for most developing and emerging market countries.

⁵For benchmark versions, see Hein (2014, chap. 7) and Blecker (2011).

⁶Bulgaria, Bolivia, Dominican Republic, Guatemala, Guyana, Jordan, and Oman are a few examples of countries that have fallen into this category for several years since the millennium.

⁷Original sin, that is, the “inability of a country to borrow abroad in its own currency” (Eichengreen, Hausmann, and, Panizza 2007, p. 122) is pervasive in developing countries, but also significant in developed countries outside the financial centers (United States, United Kingdom, Switzerland, and Japan) and the eurozone.

⁸Although many authors have claimed that a devaluation typically worsens income distribution (Alexander 1952; Diaz-Alejandro 1963; Krugman and Taylor 1978), there is little empirical research on this question. Bahmani-Oskooee (1997) finds that devaluations increase income inequality measured as the ratio of the income of the top 20% to that of the bottom 40% of the population. Dünhaupt (2017) estimates the effect of various financialisation variables on the wage share and finds import prices to exercises a negative effect on the wage share. Hence, there is some indirect evidence that devaluations more commonly raise the profit share.

⁹It has to be noted that the linear specification in Equation (11) assumes away a nonlinearity in the Marshall-Lerner condition that stems from the valuation of imports by the exchange (see Footnote 3). It can be shown that the implicit assumption behind Equation (11) is an exchange rate elasticity of import demand of −1.

¹⁰Domestic currency debt does not enter the investment function not only to keep the model parsimonious, but also because the profit share in the investment function already captures the ability of firms to obtain liquid funds in domestic currency. Domestic currency debt is also not subject to exchange rate risk and thus less risky. Moreover, I abstract from negative effects of interest payments on investment to focus the analysis on balance sheet effects. For a post Kaleckian model that analyzes effects of interest payments on investment, see Hein (2014, Chap. 9).

¹¹The Keynesian stability condition may not be satisfied in the long-run (Skott 2012). This constitutes another reason why the present model is confined to the short- and medium-run.

¹²Although in principle the central bank can set a rate above the one given by Equation (15), it is assumed that the floor given by international arbitrage conditions is a binding constraint because the central bank has no interest in raising the rate further. It might be worried about negative effects on economic activity since the domestic rate is already high due to a large premium. Furthermore, commercial banks may charge a (constant) mark-up on the central bank base rate. For simplicity, it is assumed that the central bank directly sets the domestic lending rate.

¹³UIP is a strong but straightforward assumption that serves to capture the empirical fact that monetary policy in fixed exchange rate regimes with limited foreign reserves is significantly constrained (Obstfeld, Shambaugh, and Taylor 2005; Hosny, Kishor, and Bahmani-Oskooee 2015).

¹⁴This idea is prominent in post Keynesian work on currency and exchange rate issues (e.g., Herr 2008; Andrade and Prates 2013; Kaltenbrunner 2015). Some authors use the notion of a currency premium, which is a subjective international liquidity premium that hard currencies offer because they function as relatively safe stores of wealth. The domestic interest rate premium ρ can be regarded as the inverse of such a currency premium.

¹⁵Although exchange rate policy can only manipulate the nominal exchange rate, the real exchange rate follows the nominal exchange rate quite closely, so that a nominal devaluation usually translates into a real devaluation (Razmi, Rapetti, and Skott, 2012, p. 152).

¹⁶In a survey of empirical studies over the past 50 years, Bahmani, Harvey, and Hegerty (2013) showed that empirical estimates of the MLC have often been either contradictory or changed over time. They conducted a meta-analysis of existing studies and find that the MLC is only statistically significantly satisfied in just under 30% of 92 estimated elasticities. Moreover, the authors conduct their own empirical analysis for a set of 29 countries over the period 1971–2009 and find the MLC to be met in only three countries. The case b₁ ≤ 0 is therefore entirely possible, if not likely.

¹⁷Double-asterisks denote equilibrium variables into which both steady state debt ratios have been substituted.

Additional information

Notes on contributors

Karsten Kohler

Karsten Kohler is with the Department of Economics, Kingston University London, Kingston upon Thames, England.