The role of foreign currency lending in the impact of the exchange rate on the real economy

The purpose of our article is to define how the FX debt of the private sector changes the impact of the exchange rate on the real economy: to identify the balance sheet channels through which depreciation of the exchange rate has a negative impact on GDP and the factors which determine whether the overall impact of depreciation will be contractionary or expansionary. In our analysis, we identified three balance sheet channels. Depreciation of the nominal exchange rate increases the debt burden of companies and households which are indebted in foreign currency and have no FX income, leading in turn to lower investments and consumption. Although the direct FX exposure of the banking sector is not significant, if banks face binding capital and/or liquidity constraints, changes in the exchange rate may have an indirect impact on the credit supply of banks through a number of channels. Looking at the impact of a weaker exchange rate on growth, our calculations show that the effect of depreciation on the lending ability of the banking system is of key importance. If we only take into account the impact of the exchange rate on the balance sheets of the households and corporate sector, the impact on competitiveness is presumably stronger, but the impact of depreciation on household income and the profitability of companies with FX debts and no natural hedge will use up approximately 50% of the expansionary effect of increased competitiveness. However, if there is also a strong balance sheet adjustment in the banking sector, the overall impact of depreciation may well be contractionary. The effect of the exchange rate on the banks’ credit supply should, at least in such a strong form, be considered as a temporary phenomenon associated with the crisis. In parallel with the consolidation of the global financial environment and further improvement in the capital position and profit prospects of the banking sector, the credit supply channel is also expected to attenuate.