nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2023‒02‒20
nine papers chosen by
Martin Berka
Massey University

  1. A Theory of Fear of Floating By Javier Bianchi; Louphou Coulibaly
  2. International Capital Flow Pressures and Global Factors By Linda S. Goldberg; Signe Krogstrup
  3. Real Exchange Rate and International Reserves in the Era of Financial Integration By Joshua Aizenman; Sy-Hoa Ho; Luu Duc Toan Huynh; Jamel Saadaoui; Gazi Salah Uddin
  4. Market Incompleteness and Exchange Rate Spill-over By Zhengyang Jiang
  5. Optimal policy under dollar pricing By Egorov, Konstantin; Mukhin, Dmitry
  6. Global financial cycle and liquidity management By Damiano Sandri; Olivier Jeanne
  7. The Development of Local Currency Bond Markets and Uncovered Interest Rate Parity By Park, Cyn-Young; Shin, Kwanho
  8. Signaling with debt currency choice By Egemen Eren; Semyon Malamud; Haonan Zhou
  9. Stress relief? Funding structures and resilience to the Covid Shock By Forbes, Kristin; Friedrich, Christian; Reinhardt, Dennis

  1. By: Javier Bianchi; Louphou Coulibaly
    Abstract: Many central banks whose exchange rate regimes are classified as flexible are reluctant to let the exchange rate fluctuate. This phenomenon is known as “fear of floating”. We present a simple theory in which fear of floating emerges as an optimal policy outcome. The key feature of the model is an occasionally binding borrowing constraint linked to the exchange rate that introduces a feedback loop between aggregate demand and credit conditions. Contrary to the Mundellian paradigm, we show that a depreciation can be contractionary, and letting the exchange rate float can expose the economy to self-fulfilling crises.
    JEL: E44 E52 F33 F34 F36 F41 F45 G01
    Date: 2023–01
  2. By: Linda S. Goldberg; Signe Krogstrup
    Abstract: The risk sensitivity of international capital flow pressures is explored using a new Exchange Market Pressure index that combines pressures observed in exchange rate adjustments with model-based estimates of incipient pressures that are masked by foreign exchange interventions and policy rate adjustments. The sensitivity of capital flow pressures to risk sentiment including for so-called safe haven currencies, evolves over time, varies significantly across countries, and differs between normal time and extreme stress events. Across countries, risk sensitivities and safe haven status are associated with self-fulfilling exchange rate expectations and carry trade funding currencies. In contrast, association with more traditional macroeconomic country characteristics is weak.
    JEL: F32 G11 G20
    Date: 2023–01
  3. By: Joshua Aizenman; Sy-Hoa Ho; Luu Duc Toan Huynh; Jamel Saadaoui; Gazi Salah Uddin
    Abstract: The global financial crisis has brought increased attention to the consequences of international reserves holdings. In an era of high financial integration, we investigate the relationship between the real exchange rate and international reserves using nonlinear regressions and panel threshold regressions over 110 countries from 2001 to 2020. We find the buffer effect of international reserves is more pronounced in Europe and Central Asia above a threshold of 17% of international reserves over GDP. Our study shows the level of financial-institution development plays an essential role in explaining the buffer effect of international reserves. Countries with a low development of their financial institutions may manage the international reserves as a shield to deal with the negative consequences of terms-of-trade shocks on the real exchange rate. We also find the buffer effect is stronger in countries with intermediate levels of financial openness.
    JEL: F30 F40 F44
    Date: 2023–01
  4. By: Zhengyang Jiang
    Abstract: I develop a general characterization of the effect that market incompleteness has on exchange rate dynamics. On the one hand, it weakens the pass-through from a country's marginal utility shocks to its own exchange rate movements; on the other hand, it gives rise to additional variations in exchange rates and propagates one country's marginal utility shocks to other countries' exchange rate movements. This novel international spill-over effect gives rise to both exchange rate disconnect from local fundamentals and exchange rate comovements in the cross-section of currencies, offering a novel channel for understanding these salient features of exchange rate behaviors.
    JEL: F31 G15
    Date: 2023–01
  5. By: Egorov, Konstantin; Mukhin, Dmitry
    Abstract: Recent empirical evidence shows that most international prices are sticky in dollars. This paper studies the policy implications of this fact in the context of an open economy model, allowing for an arbitrary structure of asset markets, general preferences and technologies, time- or state-dependent price setting, and a rich set of shocks. We show that although monetary policy is less eftcient and cannot implement the flexible-price allocation, inflation targeting and a floating exchange rate remain robustly optimal in non-U.S. economies. The capital controls cannot unilaterally improve the allocation and are useful only when coordinated across countries. Thanks to the dominance of the dollar, the U.S. can extract rents in international goods and asset markets and enjoy a higher welfare than other economies. Although international cooperation beneffts other countries by improving global demand for dollar-invoiced goods, it is not in the self-interest of the U.S. and may be hard to sustain.
    Date: 2023
  6. By: Damiano Sandri; Olivier Jeanne
    Abstract: We use a tractable model to show that emerging markets can protect themselves from the global financial cycle by expanding (rather than restricting) capital flows. This involves accumulating foreign liquid assets when global liquidity is high to then buy back domestic assets at a discount when global financial conditions tighten. Since the private sector does not internalize how this buffering mechanism reduces international borrowing costs, a social planner increases the size of capital flows relative to the laissez-faire equilibrium. The model also shows that foreign exchange interventions may be preferable to capital controls in less financially developed countries.
    Keywords: capital flows, foreign exchange reserves, sudden stop, capital flow management, capital controls
    JEL: F31 F32 F36 F38
    Date: 2023–01
  7. By: Park, Cyn-Young (Asian Development Bank); Shin, Kwanho (Department of Economics, Korea University)
    Abstract: This paper investigates whether the uncovered interest parity (UIP) will hold more firmly if the local currency bond markets (LCBMs) are more developed, and the presence of nonbank financial institutions (NBFIs) is expanded. Deviations in UIP decrease as LCBMs develop, while the patterns of the UIP premium in emerging markets increasingly resemble patterns in advanced economies. Capital flows respond more sensitively to the UIP premium for emerging markets when LCBMs are more developed. These suggest the development of LCBMs and NBFIs might induce more active cross-border carry trades and reduce UIP deviations. However, greater carry trade positions may increase a country’s exposure to market disruptions and exchange rate volatility. Empirical results show that gross portfolio debt inflows increase (decrease) when the exchange rate appreciates (depreciates). While LCBMs becoming more developed can mitigate the negative effect of the original sin redux hypothesis in advanced economies, this aggravates the impact of exchange rate depreciation in emerging markets.
    Keywords: uncovered interest parity; local currency bond markets; emerging economies; nonbank financial institutions; capital inflows
    JEL: E44 F34 F62 G12 G21 G23
    Date: 2023–02–09
  8. By: Egemen Eren; Semyon Malamud; Haonan Zhou
    Abstract: We document that firms in emerging markets borrow more in foreign currency when the local currency actually provides a better hedge in downturns. Motivated by this fact, we develop an international corporate finance model in which firms facing adverse selection choose the foreign currency share of their debt. In the unique separating equilibrium, good firms optimally expose themselves to currency risk to signal their type. Crucially, the nature of this equilibrium depends on the co-movement between cash flows and the exchange rate. We provide extensive empirical evidence for this signalling channel using a granular dataset including more than 4, 800 firms in 19 emerging markets between 2005 and 2021. Our results have implications for evaluating and mitigating risks arising from currency mismatches in corporate balance sheets.
    Keywords: foreign currency debt, corporate debt, signaling, exchange rates
    JEL: D82 F34 G01 G15 G32
    Date: 2023–01
  9. By: Forbes, Kristin (MIT-Sloan School of Management, NBER and CEPR); Friedrich, Christian (Bank of Canada); Reinhardt, Dennis (Bank of England)
    Abstract: This paper explores whether different funding structures – including the source, instrument, currency, and counterparty location of funding – affected the extent of financial stress experienced in different countries and sectors during the early stages of the Covid-19 pandemic. We measure financial stress using a new data set on changes in credit default swap spreads for sovereigns, banks, and corporates during the Covid Shock – the period of acute financial stress in early 2020. Then we use country-sector and country-sector-time panels to assess if these different forms of financial intermediation and internationalisation tended to mitigate – or amplify – the impact of this risk-off shock. We find that banks with a higher share of funding from non-bank financial institutions (NBFI) and that were more reliant on US dollar funding were significantly more vulnerable. In contrast, whether funding was obtained in loans (instead of debt markets) or cross-border (instead of domestically) did not significantly impact resilience. The results suggest that macroprudential regulations should broaden their current focus to take into account reliance on NBFI and dollar funding, with less priority for regulations focusing on residency (ie, capital controls). Moreover, policies directly targeting these structural vulnerabilities (ie, focused on NBFIs and USD swap lines) can have significant effects even after controlling for broader macroeconomic responses and appear more successful at mitigating stress related to these funding structures than easing more generalised banking regulations.
    Keywords: Covid-19; financial stress; funding structure; non-bank financial institutions; shadow banks; macroprudential policy; swap lines
    JEL: E44 E65 F31 F36 F42 G18 G23 G38
    Date: 2022–11–18

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