Destabilizing Stability? Exchange Rate Arrangements and Foreign Currency Debt

IMF Working Papers, August 28, 2020

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Canonical URL: Destabilizing Stability? Exchange Rate Arrangements and Foreign Currency Debt

Emerging markets (EMs) often respond to shocks by intervening in foreign exchange (FX) markets and thus preventing full exchange rate adjustment.
Such intervention can dampen the effect of shocks and increase monetary policy space but may incentivize economic participants to increase risk taking and take on more FX debt.
Empirical analysis using rolling correlations and difference-in-difference estimations suggests that a shift towards greater exchange rate flexibility often coincides with a decline in external FX debt.
Findings highlight the importance of complementary policies to address financial stability issues related to the exchange rate, including FX-specific macroprudential policies and policies aimed at promoting financial development.

Empirical approaches: rolling correlations and difference-in-difference estimations.
Subject areas listed: Exchange rate arrangements, Exchange rate flexibility, Exchange rates, External debt, Foreign exchange.
Keywords and regional scope include: Asia and Pacific; Central and Eastern Europe; Europe; Global; Middle East; North Africa; carry trade; equilibrium exchange rate; exchange rate volatility; FX Intervention; FX purchase; FX stability; Monetary Policy; regime shift; WP.

Use complementary policies to manage financial-stability issues tied to exchange rate management.
Implement FX-specific macroprudential policies to mitigate risk-taking driven by exchange rate interventions.
Promote financial development to reduce vulnerabilities associated with FX-denominated debt.