Marja Hoek-Smit
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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