Destabilizing Stability? Exchange Rate Arrangements and Foreign Currency Debt

Author/Editor:

Balazs Csonto ; Tryggvi Gudmundsson

Publication Date:

August 28, 2020

Electronic Access:

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary:

Emerging markets (EMs) often respond to shocks by intervening in foreign exchange (FX) markets and thus preventing full exchange rate adjustment. This response can serve to dampen the effect of shocks and increase monetary policy space but may also incentivize economic participants to increase risk taking and take on more FX debt. This paper empirically analyzes the role of exchange rate flexibility in affecting such risk taking, by using rolling correlations and difference-in-difference estimations. The results suggest that a shift towards greater exchange rate flexibility often coincides with a decline in external FX debt. The findings also highlight the importance of using complementary policies to deal with financial stability issues related to the exchange rate, such as FX-specific macroprudential policies and policies aimed at promoting financial development.

Series:

Working Paper No. 20/173

Frequency:

regular

English

Publication Date:

August 28, 2020

ISBN/ISSN:

9781513555928/1018-5941

Stock No:

WPIEA2020173

Format:

Paper

Pages:

24

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