Exchange Rate Driven Balance Sheet Effect and Capital Flows to Emerging Market Economies

Turkish firm-level data suggests that firms borrowing from domestic banks have, on average, a higher degree of currency mismatch than firms with direct access to international financial markets. Higher FX exposure for the former group implies that their balance sheet are more likely to deteriorate when the local currency depreciates. This risk might in turn spillover onto creditors, potentially affecting the financial health of domestic banks. In a set of emerging market economies, I indeed find that when global liquidity tightens, domestic banks are more adversely affected by the above described channel, than firms with direct access to international financial markets. When the US$ index is countercyclical over the global credit cycle, countries whose foreign currency liabilities are heavily weighted in US$ experience a larger valuation effect. Using this variation to identify the exchange rate driven balance sheet effect, I find that banking sectors in countries heavily indebted in US$ have more difficulties accessing foreign funds when global liquidity tightens. In the same countries, this additional hindrance is however absent for firms with direct access to international financial markets. I develop a partial equilibrium model whose predictions are consistent with these results. The results favor the implementation of FX-related macro prudential policies during periods of abundant global liquidity. These policies should reinforce the financial stability of the banking system at a potential reversal of global funds.