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Transmission Channels of Global Liquidity in Emerging Market Economies

Abstract

I study the role of banks, exchange rates, and firms in the transmission of global liquidity in emerging market economies. This close examination comprises three chapters.

The first chapter investigates the importance of the bank leverage cycle in the propagation of exchange rate fluctuations. Emerging market economies can be sensitive to large currency depreciation because it may increase the default risk of firms that have their liabilities in foreign currency and assets in local currency. Since banks adjust their leverage based on the riskiness of borrowers, bank credit flows should inform us whether corporate balance sheets are affected by exchange rate fluctuations. Using country level differences in the foreign currency decomposition of bank claims, I construct an instrument to disentangle the effect of exchange rate fluctuations on bank loans. I find that a 1\% real depreciation of the local currency causes a 1.36\% reduction in foreign currency loans channeled by domestic banks. This significant response is however absent for direct loans by global banks. I explain this with a model that takes into account balance sheet differences of ultimate borrowers. Firms that borrow from domestic banks are more likely to be local firms subject to currency mismatch while firms that can borrow directly from global banks are multinational corporations with resources to hedge them against foreign currency fluctuations. The results have two major implications. First, the risk sensitive lending behavior of banks plays an important role in the propagation of exchange rate fluctuations. Second, policy makers should enforce domestic banks to monitor the foreign currency exposure of their clients more closely.

DSGE models have a shortfall in simulating the sensitive nature of emerging market economies to global financial conditions. The second chapter contributes on that aspect by providing a new theoretical mechanism that amplifies the effect of world interest rates. Moral hazard arises when corporate borrowers prefer investing in riskier projects when interest rates rise, which in turn influences the financial intermediary's willingness to lend. To the extent that world interest rates are transmitted to domestic interest rates, the lending behavior of the financial intermediary amplifies the effect of world interest rates. I empirically investigate this theoretical finding using a structural VAR. Results indicate that a global financial tightening is immediately followed by a drop in domestic bank credit while investment and output also decrease significantly, consistent with the amplification of global financial shocks induced by moral hazard.

After the Global Financial Crisis (GFC), three trends highlight international financial markets for emerging market economies, historically low term premium in the yield curve, the emerging corporate bond boom in foreign markets, and the stagnation of emerging market banks cross-border liabilities. The final and third chapter links these post GFC trends to US unconventional monetary policy in a theoretical framework. In addition, I investigate whether firm size matters in terms of sensitivity to this financial spillover. The model shows that, when the term premium of corporate bond yields rise, large firms divert their funding from foreign lenders to domestic banks, crowding small firms out of domestic bank credit markets. The evolution of small firms' share in the total bank credit for a sample of emerging market economies validate the findings of the model. Emerging market policymakers should therefore ease financing for small firms as the Fed and central banks of other advanced economies normalize the size of their balance sheet.

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