Exchange rates and the transmission of global liquidity

Speech by Mr Hyun Song Shin, Economic Adviser and Head of Research of the BIS, at the Bank of Korea-IMF conference "Leverage in Asia: Lessons from the Past, What's New Now?, and Where to Watch Out For?", Seoul, 11 December 2015.

What is the economic impact of currency depreciation? Is it expansionary or contractionary? Traditional arguments in the spirit of the Mundell-Fleming model suggest that it is expansionary as it boosts net exports and output. But the combination of slowing growth and deep depreciations in emerging market currencies suggest that the traditional explanation is incomplete. Borrowing in international currencies generates another link between exchange rates and economic activity that operates through financial channels; currency depreciation undermines balance sheet strength and tightens financial conditions, sapping economic activity. Government fiscal positions suffer knock-on effects due to increased tail risks, further tightening financial conditions and amplifying the downturn. Even the deployment of large central bank foreign exchange reserves may not be sufficient to reverse such a growth slowdown.