Macroprudential FX regulations: Shifting the snowbanks of FX vulnerability?

Borrowing in a foreign currency exposes an economy to sudden stops, sharp depreciations and banking crises, and constrains what monetary policy and the exchange rate can do; so a growing number of countries regulate how much foreign currency (FX) exposure their banks may carry. This paper asks two questions about those rules – do they work, and do they merely move the risk – and answers both, with a model first and then a purpose-built dataset. The model extends Holmstrom and Tirole (1997) by adding a currency dimension: banks can pay to screen borrowers and so distinguish unproductive, low-productivity and high-productivity firms, while market investors “can only lend indiscriminately”; FX funding is cheaper than domestic-currency funding but carries exchange rate risk, and when the domestic currency depreciates low-productivity firms and their banks default. Tightening FX regulation raises banks’ FX funding cost (if liability-side) or the lending rate they charge (if asset-side), banks stop lending to low-productivity firms, and those firms shift part of their FX borrowing to investors – so total factor productivity falls and the welfare effect is explicitly ambiguous, trading the reduced social cost of bank failure after depreciations against the output cost of a less efficient allocation of FX credit. Four testable predictions follow: banks borrow and lend less in FX with no change in domestic-currency borrowing; some firms shift to FX borrowing from market investors with no increase in non-FX borrowing by firms or banks; banks’ exchange rate exposure falls significantly; and firms’ exposure falls moderately, by less than banks’. The empirical test uses a new dataset assembled from four existing sources covering 132 tightenings or loosenings of macroprudential FX regulation across 48 countries (17 advanced, 31 emerging) from 1995 to 2014, with reserve-issuing economies and most offshore centres excluded, run against quarterly BIS banking and international debt statistics over 1996Q1-2014Q4 in panels with country and global-time fixed effects. All four predictions are borne out. Cross-border FX loans to banks fall by 0.50 to 0.66 percent of GDP over the following year – about a third of the sample median of 1.9 percent of GDP, and more than half for countries such as Brazil and Indonesia – with no significant change in banks’ non-FX borrowing. Corporate international FX debt issuance rises by 0.05 to 0.06 percent of GDP, roughly 10 percent of median annual FX issuance overall and 15 to 20 percent for Brazil and Indonesia, with no significant change in corporate non-FX issuance or in bank issuance in any currency. Comparing the two, about 10 percent of the FX exposure withdrawn from banks reappears as corporate debt issuance, rising to 16 percent when only liability-side measures are used. On resilience, a one percentage point depreciation cuts financial-sector stock returns by 1.46 percentage points when the regulatory stance is neutral but only 0.67 points when FX regulations have been tightened; for the broad market index the corresponding fall is from 1.18 to 0.75 points, and the interaction is statistically significant at 5 percent only for banks. The authors are explicit about what this does not settle: the data miss FX exposure that never crosses a border, third-country transactions, and hedging of any kind, and the paper “does not provide a full cost-benefit calculation of the impact of macroprudential regulations.”

Journal of Financial Economics | Macro Paper Warehouse

Macroprudential FX regulations: Shifting the snowbanks of FX vulnerability?