Financial Exchange Rates and International Currency Exposures

Abstract

Our goal in this project is to gain a better empirical understanding of the international financial implications of currency movements. To this end, we construct a database of international currency exposures for a large panel of countries over 1990-2004. We show that trade-weighted exchange rate indices are insufficient to understand the financial impact of currency movements. Further, we demonstrate that many developing countries hold short foreign currency positions, leaving them open to negative valuation effects when the domestic currency depreciates. However, we also show that many of these countries have substantially reduced their foreign currency exposure over the last decade. Last, we show that our currency measure has high explanatory power for the valuation term in net foreign asset dynamics: exchange rate valuation shocks are sizeable, not quickly reversed and may entail substantial wealth shocks.

Financial Globalisation and the Crisis

“…More generally, credit growth is an important leading indicator of subsequent financial crises, with recent estimates provided by Jorda et al (2011) and Gourinchas and Obstfeld (2012). In related fashion, Lane and Milesi-Ferretti (2012) show that the scale of pre-crisis " excess" current account deficits has been associated with larger current account turnarounds over 2008-2010, which were mostly accomplished through reductions in domestic absorption.…”

“…The liberalisation of the European financial system and the launch of the euro provided further impetus to cross-border financial trade (Lane 2006, Lane 2010. Regulatory harmonisation and freedom of establishment facilitated the integration of European financial markets, while the single currency led to especially rapid growth in cross-border trade in money and credit markets.…”

“…Relative to countries with independent currencies and/or with foreign-currency liabilities, ECB liquidity flows have been a stabilising force during the crisis, ameliorating the impact of the large-scale private-sector reversal in capital flows. For instance, Lane and Milesi-Ferretti (2012) calculate that liquidity inflows grew from virtually zero during the pre-crisis period to 2010 values of 54 percent of GDP for Ireland, 22 percent for Greece and 17 percent for Portugal. In related fashion, cross-border liquidity flows are the source of the large Target 2 imbalances that have emerged since the onset of the crisis.…”

The Geographical Composition of National External Balance Sheets: 1980-2005

“…Although the numbers are only released as aggregates across industrialized and developing countries, disaggregated data have been used in some previous studies. We follow the approach in Lane and Shambaugh (2007) and use the results reported in those studies to obtain estimates of the currency composition of reserves for countries that are not part of the G-10.…”

Real financial market exchange rates and capital flows

“…By doing so, we explicitly consider Lane and Shambaugh's (2010) observation that the tradeweighted exchange rate indices are insufficient to provide a full understanding of the financial impact of currency movements. These authors create a financially weighted exchange rate index based on the composition of foreign assets and liabilities in order to investigate the impact of currency movements on the capital gains and losses of foreign assets and liabilities.…”