The dollar exchange rate as a global risk factor: evidence from investment
BIS Working Papers No 695
Exchange rates usually crop up in connection with international trade, but they also affect the economy through a financial channel. We investigate how this financial channel operates, and what impact it has on real investment. We also examine what the financial channel of exchange rates implies about the link between the strength of the US dollar, cross-border bank flows and real investment.
The paper adds to the evidence of the existence of the financial channel of exchange rates. It shows how the financial channel of exchange rates affects real investment, not just financial conditions. The effect on investment that we identify goes in the opposite direction to the textbook channel that emphasises trade competitiveness resulting from currency movements. In our story, a stronger dollar is associated with subdued real investment in emerging market economies (EMEs).
A stronger dollar tends to go hand in hand with more restrained investment activity in EMEs. In this sense, the dollar exchange rate is a barometer for risk appetite supporting real economic activity. Looking deeper, the link between the dollar and global investment originates in the way that the dollar affects credit supply conditions, especially credit supplied by banks. The body of evidence is also bolstered by the way that a stronger dollar tends to go together with more subdued cross-border bank lending. Importantly, the financial channel influences the real economy in the opposite direction to the standard trade channel, in that a depreciation of an EME currency against the dollar tends to dampen economic activity.
Exchange rate fluctuations influence economic activity not only via the standard trade channel, but also through a financial channel, which operates through the impact of exchange rate fluctuations on borrowers' balance sheets and lenders' risk-taking capacity. This paper explores the "triangular" relationship between (i) the strength of the US dollar, (ii) cross-border bank flows and (iii) real investment. We conduct two sets of empirical exercises - a macro (country-level) study and a micro (firm-level) study. We find that a stronger dollar is associated with lower growth in dollar-denominated cross-border bank flows and lower real investment in emerging market economies. An important policy implication of our findings is that a stronger dollar has real macroeconomic effects that go in the opposite direction to the standard trade channel.
JEL classification: F31, F32, F34, F41
Keywords: financial channel, exchange rates, cross-border bank lending, real investment