US monetary policy and the financial channel of the exchange rate: evidence from India

BIS Working Papers  |  No 945  | 
28 May 2021



Over the past decade, non-financial firms in emerging market economies (EMEs) have rapidly built up dollar debt. This makes them vulnerable to changes in US monetary policy. If a local currency weakens against the dollar, the domestic economy may shrink rather than expand if such firms have a large stock of unhedged dollar debt. Our paper examines the evidence for this hypothesis based on Indian firm-level and macro-level data.  


We ask whether financial effects arising from the exchange rate affect the international transmission of monetary policy, and how this "financial channel" might operate through the amount of credit in the economy. Using micro-level data, we find that the exchange rate does affect the balance sheets of non-financial firms when changes in US monetary policy influence the exchange rate. These effects are manifested in changes in firms' use of domestic vis-à-vis external borrowing and in their net worth. To complement the micro-level analysis, we estimate the impact of US monetary policy on the macro-financial variables.


We find that, when US monetary policy tightens, the financing conditions of Indian non-financial firms deteriorate, as their net worth falls and access to credit worsens. At the same time, a weakening rupee combined with higher US interest rates leads to a downturn in both the domestic credit and the business cycle. We find that the financial channel of the exchange rate  can intensify monetary policy dilemmas for the central bank.


The effect of US monetary policy on EMEs is one of the fiercely debated issues in international finance. We contribute to this debate using micro- and macro-level analyses from India over the period 2004-2019. Using a dynamic panel estimation model of non-financial firms, we show that US monetary tightening adversely affects firms' net worth and reduces domestic credit relative to external credit. Using a sign-identified VAR model, we find that the contractionary US monetary policy leads to a significant downturn in the domestic credit and business cycles. The responses of firms and the impact on the domestic credit cycle suggest that the financial channel of the exchange rate is one of the conduits transmitting US monetary policy to India.

JEL-classification: E32, E52, F41, F42, F61, F62.

Keywords: US monetary policy, international transmission of monetary policy, dynamic panel estimation, sign-restricted VAR model, financial channel, Indian economy.