February 5, 2012
With the increased inflow of foreign capital into emerging market economies, foreign currency credit, including mortgage credit, has increased as a proportion of domestic credit in several countries in East and Central Europe, Asia and Latin America. The high risk of such foreign exchange mortgages, for both borrowers and banks, which have to fund themselves in foreign currency, has been documented for countries in Central and Eastern Europe[i], and is related to the dangers of mismatches between currency movements and domestic market income and inflation trends. We hope to have a separate blog on that topic soon. Recent studies have shown in more detail how the relationship between capital inflows, domestic credit and exchange rate regimes works through banking intermediation. These insights are important in formulating policy responses in emerging market economies that experience foreign capital inflows.
A 2008 study by Mendoza and Torrens[ii] showed that capital inflows increase before the peak in credit booms and that such credit booms have a higher frequency in countries with a less flexible exchange rate regime. This week (February 2012) a study by Magud, Reinhart and Vesperoni[iii], using a panel of 25 emerging market countries, shows that:
-Large capital inflows, including banking system external funding, and less flexible exchange rate regimes tend to exacerbate domestic credit cycles, beyond the effect of monetary expansion associated with such inflows.
- Less flexible foreign exchange rate regimes are associated with a higher share of credit in foreign currency (e.g., a peg may be perceived as a guarantee on foreign currency claims).
This research suggests that exchange rate flexibility may be instrumental in curving the effects of capital inflows on domestic credit and hence on credit cycles. Currency regimes could therefore be used to create counteractive regulatory policy tools. Apart from allowing for greater exchange rate flexibility, regulators could target bank’s external funding and incentives to lend/borrow in foreign currency, for example by setting currency dependent liquidity requirements , increasing capital requirements for foreign exchange loans and/or introducing dynamic provisioning, tightening debt-to-income and loan-to-value ratios conditional on the debt’s currency denomination. Cross-country studies such as these are of great importance in guiding regulators in creating more dynamic policy tools to curb boom bust cycles in credit markets, and related asset markets as in the case of mortgage credit.
[i] Duebel, H-J, and S. Walley (2010), “Regulation of Foreign Currency Mortgage Loans: The Case of Transition countries in Central and Eastern Europe,” December 2010
[ii] Mendoza, E. and M. Torrens (2008), “An anatomy of Credit Booms: Evidence from Macro Aggregates and Micro Data,” NBER working Paper 14049
[iii] Magud, N., Carmen M.Reinhart, Estaban R. Vesperoni,“Capital Inflows, Exchange Rate Flexibility, and Credit Booms,” IMF working Paper WP12/41
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