## The Dominant Currency Financing Channel of External Adjustment

_IMF Working Papers, August 11, 2023_

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## Bibliographic details
- Authors: Camila Casas, Sergii Meleshchuk, Yannick Timmer
- Published: August 11, 2023
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400248788.001

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### Summary
- Authors: Camila Casas, Sergii Meleshchuk, Yannick Timmer
- Date: August 11, 2023
- Core finding: A new channel through which exchange rates affect trade — the dominant currency financing channel — whereby firms with greater revaluation of dominant currency debt after a home currency depreciation compress imports relatively more while exports are unaffected.
- Context: Identification exploits firms’ maturity structure of foreign currency debt around a large depreciation in Colombia.

### Identification and empirical findings
- Novel identification strategy: Exploits firms’ maturity structure of foreign currency debt around a large depreciation in Colombia.
- Main empirical results:
  - Firms experiencing a stronger debt revaluation of dominant currency debt due to a home currency depreciation compress imports relatively more.
  - Exports are unaffected by the debt revaluation of dominant currency debt.
  - Dominant currency financing does not lead to an import compression for firms that:
    - export,
    - hold foreign currency assets, or
    - are active in the foreign exchange derivatives markets,
    as these firms are hedged against a revaluation of their debt.

### Mechanism and theoretical rationale
- The findings can be rationalized through a model featuring:
  - costly state verification, and
  - foreign currency borrowing.
- Pricing practices matter: Pricing exports in the dominant currency, instead of the producer’s currency, mutes the effect of dominant currency financing on trade flows.

### Quantitative contribution to external adjustment
- The dominant currency financing channel explains a significant part of the external adjustment process in addition to the expenditure switching channel.

### Policy-relevant implications
- Hedging practices and access to foreign currency assets can mitigate import compression following a home currency depreciation.
- Exchange rate passthrough to trade may depend on currency invoicing practices; pricing exports in the dominant currency reduces the impact of balance-sheet-driven import compression.
- Consideration of firms’ foreign currency debt maturity structure is important for assessing vulnerabilities to currency depreciations.

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_Source: https://www.imf.org/en/publications/wp/issues/2023/08/11/the-dominant-currency-financing-channel-of-external-adjustment-536802_