Exchange Rates and Domestic Credit—Can Macroprudential Policy Reduce the Link?

IMF Working Papers, September 11, 2020

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Canonical URL: Exchange Rates and Domestic Credit—Can Macroprudential Policy Reduce the Link?

Examines empirically the role of macroprudential policy in addressing the effects of external shocks on financial stability.
Sample: 62 economies over the period of 2000: Q1–2016: Q4.
Methods: dynamic panel regressions; robustness checks for simultaneity and reverse causality.

An appreciation of the local exchange rate is associated with a subsequent increase in the domestic credit gap.
A prior tightening of macroprudential policies dampens the effect of exchange rate appreciation on the domestic credit gap.
Results are strong for small open economies.
Findings are robust when explicitly accounting for potential simultaneity and reverse causality biases.

Strong domestic credit pulls in additional cross-border funding, potentially further increasing systemic risk.
Targeted capital controls can play a complementary role in alleviating this feedback effect.

Subjects: Balance of payments, Capital controls, Credit gaps, Domestic credit, Exchange rates, Financial sector policy and analysis, Foreign exchange, Macroprudential policy, Money, Real exchange rates
Keywords: Capital controls, capital flow, Capital Flows, credit development, credit gap, Credit gaps, currency appreciation, Domestic credit, exchange rate, exchange rate appreciation, exchange rate movement, exchange rate shock, Exchange rates, GDP ratio, Global, Macroprudential Policies, Macroprudential policy, monetary policy, nominal exchange rate, real GDP, Systemic Risk, WP

Source: IMF Working Paper "Exchange Rates and Domestic Credit—Can Macroprudential Policy Reduce the Link?", September 11, 2020.