Winners and losers of central bank foreign exchange interventions

Economic Modelling xxx (xxxx) xxx

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Winners and losers of central bank foreign exchange interventions☆ M
ad
alin Viziniuc The Bucharest University of Economic Studies, Finance Doctoral School, Address: 11 Tache Ionescu St., 1st Floor, Bucharest, Postal Code 010352, Romania

A R T I C L E I N F O

A B S T R A C T

JEL classification: E52 F31 F41 G15

Interventions in foreign exchange markets are indispensable for most central banks and recent years have witnessed an increase in their frequency and magnitude. However, little is known about their implications on agents’ welfare. This paper investigates the topic by employing a small open economy DSGE model with savers and borrowers in both local and foreign currencies, where the central bank intervenes to smooth out exchange rate volatility by changing its foreign reserve. Interventions occur following the foreigners’ decision to sell (or buy) domestic assets, thus weakening (or strengthening) the local currency. The model allows the disentanglement of welfare implications by type of agent and source of exchange rate imbalance, which is novel in the literature, providing useful insight for central bankers. The findings highlight the benefits of interventions in the case of foreign financial shocks, especially when the level of currency mismatch in the economy is high. However, when exchange rate disequilibrium stems from domestic developments, the intervention generates winners and losers.

Keywords: Foreign exchange intervention Foreign currency loan Welfare DSGE Agent heterogeneity

1. Introduction The years after the financial crisis witnessed an increase not only in the frequency of central bank interventions1 in the foreign exchange market, but also in the amount of reserves used for this purpose. In addition, policymakers have become more transparent with respect to the rationale behind their desire to manage the exchange rate2 (BIS, 2013). This evolution of the policy framework has its roots in the risks accompanying the quantitative easing in advanced economies – the disruptive effects on the exchange rate from the 2008–2009 financial shocks being fresh in policymakers’ minds. Excess liquidity in global financial markets can generate large inflows to emerging economies on the back of the “search for yield” behaviour, which, given its ease of

reversibility, can result in sudden stops. Such events can turn into fullblown currency crises if not well attended by the monetary authorities. Another matter of concern is the fact that large inflows lead to local currency appreciation. A stronger currency tends to depress exports (local goods become more expensive) and stimulates imports at the expense of local production. These possibilities encourage central bankers either to intervene in the foreign exchange market to smooth exchange rate volatility or to build up reserves in order to be able to mitigate the effects of large capital outflows. The behaviour of central bankers, especially in emerging economies, has motivated the literature3 to revisit the channels whereby sterilised foreign exchange interventions affect the economy. In this respect, the theoretical framework that gained broad support refers to an enhanced version of the portfolio-balance theory.4 This approach was recently

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The author hereby expresses his gratitude to the Editor of the journal (Sushanta Mallick) and to the two anonymous referees for their valuable comments and suggestions that enhanced the merit of this work. In addition, the author would like to thank Ciprian Necula and Alexandru Leonte for the fruitful discussions and advices. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors. E-mail address: madalin.viziniuc@fin.ase.ro. 1 Many central banks from emerging economies display a resistance towards allowing the exchange rate to float freely; this behaviour is acknowledged as “fear of floating”, in the terminology used by Calvo and Reinhart (2002). 2 The mix between managing interest rates and foreign exchange interventions is found to provide satisfactory results in terms of economic stabilisation in emerging economies (Mallick and Sousa, 2012). 3 In an influential paper, Backus and Kehoe (1989) show that sterilised foreign exchange interventions have a neutral effect on the exchange rate. This result is based on the assumption that financial assets are perfectly substitutable. 4 In the literature, there are alternative theoretical channels through which sterilised foreign exchange interventions could work. For example, Chang (2018) stresses that such operations have an impact on economic variables only when the economy-wide financial constraints are binding. This happens because, in the case of a purchase or sale of foreign reserves, the reverse operation requires changes of the assets held by the central bank in the banking sector. This movement loosens or tightens the financial constraint that has an impact on commercial banks’ lending activity. https://doi.org/10.1016/j.econmod.2020.02.016 Received 20 May 2019; Received in revised form 7 February 2020; Accepted 9 February 2020 Available online xxxx 0264-9993/© 2020 Elsevier B.V. All rights reserved.

Please cite this article as: Viziniuc, M., Winners and losers of central bank foreign exchange interventions, Economic Modelling, https://doi.org/ 10.1016/j.econmod.2020.02.016

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that renders domestic economy as being riskier. At this point, international financial intermediaries will seek to sell part of their holdings of local assets. This decision generates an excess supply of local currency in the foreign exchange market, which will determine a reduction of currency value (i.e. it depreciates). When caring about the exchange rate stability, the central bank reacts by purchasing the excess of local assets, which restores the demand-supply equilibrium. At this point, the depreciation pressures are mitigated (the exchange rate is less volatile), which, all things being equal, translates into a lower volatility of domestic variables (inflation, income and output), thus increasing agents’ welfare. However, in the case of a domestically originated shock that alters the competitiveness position of the economy, the central bank’s intervention to defend the exchange rate generates winners and losers. In order to illustrate this, let us consider an exogenous increase in exporters’ producer cost (simulated by an export price mark-up hike in the model). This type of disturbance reduces the foreign demand for local products, pushing output below equilibrium; the inflation rate closely follows. All things being equal, a drop in local inflation generates a real effective exchange rate depreciation, which offsets in part the initial drop in exports. Therefore, if the central bank intervenes by using foreign exchange interventions to neutralise the real exchange rate depreciation, the reduction in exports is higher. Consequently, the drop in inflation is larger, resulting in a stronger adjustment of domestic interest rates in order to stimulate economic recovery. Note that a reduction in interest rates facilitates real exchange rate depreciation, resulting in a trade-off between the uses of these two instruments. This tension is passed through to the economic agents, since the savers would prefer more stability with respect to domestic variables, whereas on the borrowers’ side, a more tightly managed exchange rate is preferred. In addition, this paper looks at the implications of a significant stock of loans denominated in foreign currency. From a bird’s eye view it appears that, given the entire stochastic environment of the modeleconomy, the social welfare suffers only smaller changes if the share of foreign currency loans widens. Zooming in, however, reveals that welfare losses observed for savers are almost entirely offset by gains on the borrowers’ side. Intuitively, domestic supply-side shocks (which are the dominant force in the model design) generate trade-offs for the monetary policy that decrease the efficacy of the policy instrument in addressing local imbalances. As such, when the share of foreign currency loans increases, the monetary policy response has to be larger (without much success in terms of stabilising the economy). By comparison, due to larger changes in nominal interest rates, the exchange rate is more stable. Since the borrowers’ income is sensitive to exchange rate volatility (more in the case of those who take foreign currency loans), they feel better when monetary policy acts more towards restoring equilibrium. However, in the case of external financial shocks – which create lower trade-offs for the central bank – the tension between external and domestic variables’ volatility is solved by the central bank in favour of the latter. Hence, savers display higher welfare when the share of foreign currency loans widens. The results presented in this paper offer policymakers in small open economies an enhanced picture of effects of foreign exchange interventions for the well-being of economic agents. Such information may prove valuable when designing an effective monetary policy response to various shocks. Therefore, the use of (sterilised) foreign exchange interventions may be favoured when the economy is affected by an external financial shock and the level of local agents’ indebtedness in foreign currency is particularly high. However, when the change of (real) exchange rates is generated by developments in the local economy (such as changes in the local producers’ competitiveness position), the decision to intervene in the foreign exchange market creates significant policy tradeoffs. This tension is due to the emergence of an inverse relation between the volatility of the interest rate and that of the exchange rate respectively. The remainder of this paper is structured as follows. The next section

proposed by Basu et al. (2018); Gabaix and Maggiori (2015); Reinhart et al. (2011) and was used in a general equilibrium framework by, inter alia, Alla et al. (2017); Benes et al. (2015); Cavallino (2019). The underlying mechanism emphasises the fact that assets held by foreign investors are imperfect substitutes. Hence, purchases or sales of foreign assets by central banks lead to a change in the ratio between domestic and foreign assets in the non-residents’ balance sheet, which, in turn, affects their desire to sell the local securities. These movements are reflected in the sovereign risk premium, since its value depends on the economy-wide debt level held by non-residents. Support for the portfolio balance channel came from empirical investigations. Adler et al. (2019); Blanchard et al. (2015); Daude et al. (2016); Fatum and Yamamoto (2014); Fratzscher et al. (2019); Keefe and Shadmani (2018) among others, have concluded that central bank purchases or sales of foreign reserves have a material effect on the exchange rate. This is particularly true especially when the interventions are large enough and the central bank has credibility among market participants that it will defend the value of the currency. Furthermore, there is evidence suggesting that foreign exchange interventions have a persistent5 effect on the real exchange rate, lasting well over one year (Adler et al., 2019; Blanchard et al., 2015). However, the number of papers that evaluate the effects of foreign exchange interventions in terms of consumer welfare is rather limited. Alla et al. (2017), show that sterilised foreign exchange can mitigate losses associated with international financial shocks; a similar conclusion is drawn by Benes et al. (2015). Nevertheless, the latter authors find that such policy action is not always beneficial for consumers’ welfare. However, when appreciation pressures are generated by non-manufacturing sectors (like in a Dutch disease episode), a foreign exchange intervention that addresses the strengthening of the currency improves social welfare (Faltermeier et al., 2017). As for the implementation strategy, Basu et al. (2018) show that rules offer better outcomes in terms of social welfare in comparison to discretion. Against this background, this paper delves into the implications of central banks’ foreign exchange interventions. The present study complements the aforementioned approaches by putting an emphasis on agents’ heterogeneity. More precisely, the model features both a representative household and a representative entrepreneur that receive utility from consumption of final goods. A key difference among these agents is that the former saves income surpluses whereas the latter needs external funds in order to finance current consumption expenditures. Agent heterogeneity, coupled with the availability of both local and foreign currency loans, allows highlighting the main result of the paper, according to which central bank foreign exchange interventions triggered by a domestic shock generate winners and losses, resulting in a trade-off for policymakers. This paper is among the first to study the implications of central bank interventions in the foreign exchange market with respect to consumer welfare for various types of agents in a rich-featured structural model. In doing so, it connects with three different strands of the literature – the one related to small open economy structural models, to studies on the efficacy of central bank interventions in the foreign exchange market and, to a smaller degree, the research on heterogeneous agents. Turning to the main findings of this paper, in the case of a sovereign risk premium shock, which reverberates throughout the economy via the exchange rate, the central bank’s intervention in the foreign exchange market increases welfare for all agents, regardless of their type. To illustrate the mechanism, let us assume an unfavourable financial event

5 The studies that focus on spot exchange rate concluded, in general, that the effects of foreign exchange interventions are short-lived (Keefe and Shadmani, 2018). However, this result does not contradict those obtained when focusing solely on the real exchange rate. In the presence of nominal rigidities, relatively small changes to spot rates can have persistent effects on the real exchange rate, due to slow adjustment of prices (Cavallino, 2019).

2

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receive all profits from central bank operations. The production sector has three stages. First, homogenous intermediate goods are made by specialised producers operating in a competitive environment, by renting labour and capital from specialised aggregators, who, in turn, combine capital services from each type of entrepreneurs. Labour is employed from unions, which set the wages in a Calvo fashion. In the next stage of production, the homogenous intermediate goods are sold to domestic or to export-oriented retailers. Their role is to differentiate the intermediate goods, a process that allows them to charge a mark-up above the purchasing price. Their final price is set using a Calvo framework, where only part of retailers has the opportunity to set a new price. The remaining agents are forced to use an indexation scheme that takes into account the latest-period consumer price inflation rate and the inflation target. Apart from these two types of retailers, the model incorporates importing retailers (who take intermediate foreign goods and differentiate them) and re-exporting retailers. Lastly, the final homogenous goods are produced by specialised agents who combine goods purchased from domestic and from importing retailers. As far as the banking sector is concerned, the design borrows from Gerali et al. (2010). The banks are arranged in a three-tiered system, with wholesale, retail and commercial banks, respectively. The attributes of the former consist of loan creation (in both domestic and foreign currency) that are later on offered to specialised retail banks. The retailers are of two types, one for each loan category (domestic or foreign denominated). They operate in a monopoly environment and face adjustment costs, in line with interest rate changes for loans offered to commercial banks. Retail banks are introduced in order to account for nominal stickiness, which generates an imperfect pass-through of interbank rates to entrepreneurs’ lending rate, alongside the usual inertia that accompanies such a financial friction. Finally, there are commercial banks that act as aggregators of differentiated loans provided by retail banks, which are later on offered to entrepreneurs. In the following sections, only the important parts of the model are described in detail,6 since many of other characteristics are, to some extent, standard.

presents the key characteristics of the theoretical model, the third section describes the calibration and estimation procedure, along with relevant findings, the fourth section explores the macroeconomic implications of foreign currency loans, the fifth section looks deeper into the welfare effects of foreign exchange interventions, and the sixth section concludes. 2. The model choice This paper employs a dynamic stochastic general equilibrium (DSGE) model based on the new-open macroeconomics literature (see, inter alia, Gali and Monacelli, 2005; Lubik and Schorfheide, 2005). Traditionally, macro-models proposed for small open economies ignore balance sheet effects determined by exchange rate fluctuations. To address this limitation, the model used in this paper introduces two types of entrepreneurs, one that prefers loans denominated in domestic currency (DCL) and another in foreign currency (FCL). Alongside the funds borrowed from the banking sector, both agents use income from renting capital services to intermediate good producers to finance expenditures on consumer goods and acquisitions of new capital from capital producers. The introduction of the wealth channel provides incentives for the central bank to engage in foreign exchange interventions, apart from the standard channels of exchange rates influences. Intuitively, this new addition allows for immediately (short-term) effects on consumption and investment, since any exchange rate swing affects the budget constraint (loosening or tightening) of those who borrow in foreign currency – all other revenues and expenditures are expressed in the local currency. In addition, the model features aggregate uncertainty by assuming that the capital owned by entrepreneurs can be affected by a quality shock. In this respect, an agent goes bankrupt if the value of his capital holdings (conditional on the realisation of the idiosyncratic quality shock) is below the level of outstanding debt. This possibility generates additional costs for lenders, which are passed on to the interest rate, affecting aggregate economic activity – this mechanism (i.e. financial accelerator) proves to be important in explaining business cycle variations in developed markets. As for developing ones, Fernandez and Gulan (2015), using a large firm level dataset, find strong evidence that supports the relevance of the financial accelerator mechanism, since it is able to account for the countercyclical characteristics of the firm leverage observed empirically (a similar result is also shared by García-Cicco et al., 2010). Moreover, by using a similar model with the one in this paper, Alla et al. (2017) show that when the financial accelerator is strong (and the risk of indeterminacy is high), by resorting to foreign exchange interventions, the central bank reinforces the credibility of the inflation targeting regime and, hence, increases the stability of the economy. Another dimension in which the standard small open economy DSGE model is improved refers to the introduction of specialised firms importing goods that are later used by exporters to manufacture the foreign traded goods. This process (which is referred to as re-exporting) is much more intense when numerous cross-border firms populate the economy. This is due to the fact that in general these firms import intermediate products from affiliates located in other countries (see, for example Amiti et al., 2014), which contributes, to some extent, to an increased integration of domestic firms into global value chains (Baldwin and Lopez-Gonzalez, 2015). This latter aspect serves as the main argument for the reduced sensitivity of exports to exchange rates movements seen in recent decades. Likewise, in the model economy used in this paper, this mechanism acts like a damper for the pass-through of exchange rate movements. Under this assumption, part of exporters’ marginal cost is hedged against exchange rate movements (imports are expressed in the same currency as exports). The remaining model is fairly standard and in line with traditional DGSE models (Christiano et al., 2005; Smets and Wouters, 2007). Apart from entrepreneurs, there are infinitely-lived households, who consume final homogenous goods, work in the intermediary sector and deposit part of their income with banks. Households own all the productive capacities of the economy, as well as the banking sector. Additionally, they

2.1. Entrepreneurs’ decisions and the lending contract In what follows, a more detailed review of the entrepreneurs’ problem is presented. In the model, there are two types of entrepreneurs, differentiated by their preference for domestic (noted with D) or foreign currency-denominated loans (marked with F). The population share of the latter, which is noted with ð1  ηL Þ, is given by the amount of foreign currency loans in total loans granted by the banking sector. Since the setup of both types of entrepreneurs is similar, the remainder of this section will focus on the ones that borrow in foreign currency. The entrepreneurs’ main objective is to consume (cF;t ) as much as possible over their lifetime, a fact captured by the utility function: UEF;t ¼ Et


X ∞ s¼0

βtþs F εCE;tþs

  ðcF;tþs ðjÞ  hF cF;t1þs ðjÞÞ1σ F 1  σF

(1)

where βF is the discount factor, σ F is the risk aversion parameter and hF is the habit formation. εCE;t is a structural shock that affects the intertemporal allocation of consumption. From an operational point of view, the entrepreneurs’ core business is to rent capital services to intermediate goods producers; the capital stock is purchased each period from specialised capital producers who build new productive capacities after transforming the latest period’s depreciated capital (already used in the production process) bought from (nondefaulting) entrepreneurs. However, compared to households, entrepreneurs’ value present consumption more. This fact makes them to be willing to borrow

6

3

A comprehensive list of model equations is presented in the Appendix.

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second integral assesses the amount of aggregate loan repayments excluding the ones that are defaulted on. Once all shocks, including the idiosyncratic one, have realised, the state-contingent interest rates on foreign currency loans RSLF;tþ1 and the threshold value are chosen to satisfy the participation constraint. By making use of Equation (2) and resorting to some common notations from the literature (see, for instance, Forlati and Lambertiní, 2011), the participation constraint (Equation (3)) can be written more compactly as:

extra funds from the baking sector on the back of the value of their collateral holdings (i.e. productive capital). At this point, it is assumed that once the terms of lending have been agreed on (similar to Bernanke et al., 1999, and more recently Forlati and Lambertiní, 2011; Paries et al., 2011), the capital stock of each entrepreneur j is affected by  an idiosyncratic quality shock, noted by ωF;tþ1 ðjÞ logðωF;tþ1 Þ  N  σ 2ω

F ;tþ1

2

 ; σ 2ωF ;tþ1 logðσ ωF ; tþ1 Þ. The realisation of this shock will determine

whether entrepreneurs choose to repay their loans. Borrowers will default if their outstanding level of loans given by RSLF;tþ1 Stþ1 LF;tþ1 ðjÞ is larger than their capital holdings, given the realisation of the quality shock ωF;tþ1 ðjÞ. In this case, without any obstruction, retail banks can retrieve the remaining capital from those who opt to default. Alternatively, when the value of the quality idiosyncratic shock is high enough, the borrower will repay the debt. In this respect, a threshold value ωF;tþ1 for the quality shock can be defined, at which the borrower repays the borrowed funds – the following equation is the same for each agent, therefore j subscript can be dropped: RSLF;tþ1 Stþ1 LF;tþ1 ¼ ωF;tþ1 PKF;tþ1 ð1  δk ÞkF;tþ1

RLF;t Stþ1 LF;tþ1 ¼ ½ΓðωF;tþ1 Þ  μBF GðωF;tþ1 ÞPKF;tþ1 ð1  δk ÞkF;tþ1

where ΓðωF;tþ1 Þ the gross share of expected value for the capital that goes to the lender. ½1 FðωF;tþ1 Þ is the fraction of loans repaid to the banks. GðωF;tþ1 Þ is the expected value of the idiosyncratic shock in the case of defaulting entrepreneurs; in other words, this variable reflects the mean value of the quality shock of those who fell below the cut-off value ωF;tþ1 : Naturally, ½ΓðωF;tþ1 Þ μBF GðωF;tþ1 Þ can be interpreted as an endogenous Loan-To-Value ratio. Equation (4) represents the constraint for those entrepreneurs who borrow in foreign currency; for the agents who prefer loans granted in local currency, the equation is similar, less the influences induced by the exchange rates. This difference translates into heterogeneous response to shocks between entrepreneurs’ classes. For example, in the case of FCL entrepreneurs, an exchange rate depreciation generates upward adjustments in the Loan-To-Value ratio, which translates into a higher default rate, since the value of FCL expressed in local currency increases. On the capital side, as the activity deteriorates, investment demand softens, which determines a drop in capital prices. This adds to the required increase in Loan-To-Value in order to offset higher local denominated debt. Therefore, for FCL entrepreneurs, the overall effect of the financial accelerator is supplemented by valuation effect due to alternation of exchange rates. Moving forward, in this framework it is (implicitly) assumed that entrepreneurs have access to insurance contracts against the idiosyncratic shock that cannot be seized by the commercial banks. As such, their initial capital endowment is the same for all individual entrepreneurs and investment is equally assigned among entrepreneurs. Furthermore, the model assumes that after the monitoring cost has been paid, there are no other barriers (like regulations or legal impediments) affecting the banks’ ability to recover the remaining collateral. Moreover, banks diversify the risk attached to the lending activity by granting loans to a large number of entrepreneurs. At this point, the majority of elements needed to write-down the budget constraint are presented. On the expenditure side, in each period an entrepreneur consumes goods cF;t ðjÞ, purchases new installed capital kF;tþ1 ðjÞ, repays his debt (including interest rates) RLF;t1 St LF;t ðjÞ and pays taxes to the general government τt ðjÞ. The incoming cash flow consist of new loans, sales of last-period depreciated capital (which accounts for those who defaulted) and income from renting productive capital to local producers. The budget constraint faced by entrepreneurs is:

(2)

With respect to notations, RSLF;tþ1 is the interest rate charged by commercial banks, Stþ1 is the nominal exchange rate, PKF;tþ1 is the price of capital. LF;tþ1 is the amount of loans borrowed from the banking sector and kF;tþ1 is the capital stock held by FCL entrepreneurs. The latter two variables, alongside the value of quality cut-off ðωF;tþ1 Þ are predetermined (i.e. their trajectory was decided in the previous period). δk is a parameter that approximates the depreciation rate of capital, which is the same for all entrepreneurs. All things being equal, Equation (2) assumes that in the case of an exchange rate depreciation (which expands the amount of debt expressed in local currency) the number of agents who do not meet the threshold increases. Consequently, the default rate for these agents surges; exchange rate volatility reverberates directly with the intensity of financial frictions in the economy. At this point, it is useful to briefly review the financial contract between lenders and borrowers. Loans are extended to entrepreneurs by commercial banks, who take the required funds from the retail banks. These agents operate in a competitive environment and play the role of loan aggregators (of differentiated types taken from retail banks). Similar to Bernanke et al. (1999), lending in the economy is possible by using a one-period loan-contract that contains the amount of funds that has to be repaid to the banks, including the lending rate. The timing of the contract assumes that the capital quality shock materialises after the loan contract is signed and, thus, is not observed by the bank. In order for the lender to observe the realisation of the productivity shock and to retrieve any remaining collateral in case of entrepreneurs’ default, they have to pay an auditing cost μBF specified as a fraction of defaulters’ assets. Commercial banks are willing to provide funds to entrepreneurs if the following constraint holds: Z

ωF;tþ1

RLF;t Stþ1 LF;tþ1 ðjÞ¼

Z

0

þ

∞

ωF;tþ1

(4)

Pc;t cF;t ðjÞ þ PKF;t kF;tþ1 ðjÞ þ RLF;t1 St LF;t ðjÞ þ τt ðjÞ ¼ St LF;tþ1 ðjÞ þ ½1  μBF GðωF;t ÞPKF;t ð1  δk ÞkF;t ðjÞ þ RKF;t kF;t ðjÞ

ωF;tþ1 ðjÞð1 μBF ÞPKF;tþ1 ð1δk ÞkF;tþ1 ðjÞfF;tþ1 ðωÞdω

(5)

where Pc;t is the consumer price, PKF;t is the price of the capital purchased by FCL entrepreneurs and RKF;t is the rental rate of the capital. The representative agent maximises the utility function (Equation (1)) subject to the commercial banks’ participation constraint (Equation (4)) and the budget constraint (Equation (5)) with respect to consumption cF;t , to new loans denominated in foreign currency LF;tþ1 , to capital stock kF;tþ1 and with respect to the default threshold ωF;tþ1 . The first order conditions (in real terms) are as follows:

RSLF;tþ1 ðjÞStþ1 LF;tþ1 ðjÞfF;tþ1 ðωÞdω (3)

where fF;tþ1 ðωÞ is the normal probability distribution function of ωF;tþ1 and RLF;t is the interest rate at which commercial banks get financed, which, as well, enters in the pool of predetermined variables. The first part (integral) from the right side evaluates the amount of collateral which is retrieved by the commercial banks, adjusted with the cost of monitoring entrepreneurs’ activities, if the borrower defaults. The

εCE;t ðcF;t  hF cF;t1 ÞσF  βF hE Et ½εCE;tþ1 ðcF;tþ1  hF cF;t ÞσF  ¼ pc;t ΛF;t

4

(6)

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  qtþ1 qtþ1 π tþ1 ΛF;t ¼ Et βF ΛF;tþ1 * RLF;t þ ΛF;tþ1 ψ F;tþ1 RLF;t * π tþ1 qt π tþ1    pKF;t ΛF;t ¼ Et βF ΛF;tþ1 ½1  μBF GðωF;tþ1 ÞpKF;tþ1 ð1  δk Þ þ rKF;tþ1

þ ΛF;tþ1 ψ F;tþ1 ½ΓðωF;tþ1 Þ  μBF GðωF;tþ1 ÞpKF;tþ1 π tþ1 ð1  δk Þ 

Et ½ψ F;tþ1  ¼ Et

βF

π tþ1

(7)

multiplier, R*t is the foreign interest rate, π *t is the foreign inflation and φRP;t is the risk premium (as in Schmitt-Grohe and Uribe, 2003), defined as:

(8)


  qt lIB* ;t  LIB* εRP;t φRP;t ¼ φRP exp κ RP pY;t yt



μBF G’ ðωF;tþ1 Þ ’ Γ ðωF;tþ1 Þ  μBF G’ ðωF;tþ1 Þ

where LIB* is the steady-state share of foreign debt in domestic nominal GDP (noted with pY;t yt ), εRP;t is a first order autoregressive process shock and φRP denotes the steady-state risk premium. κRP is the elasticity of risk premium to deviations from the equilibrium debt-to-GDP ratio. Gabaix and Maggiori (2015) argue that the effectiveness of foreign exchange interventions depends on the frictions affecting financial intermediaries, which is synthetically captured in this framework by the elasticity of the risk premium to economic fundamentals.

(9)

where ΛF;t is the budget constraint multiplier and ψ F;tþ1 ΛF;tþ1 is the commercial banks’ participation constraint multiplier. qt is the real exchange rate, π t domestic inflation rate and π *t foreign inflation rates, respectively. pc;t and pKF;t are the relative prices of consumption goods and capital purchased by foreign borrowing entrepreneurs.

2.3. Monetary policy and foreign exchange interventions

2.2. Wholesale banks and the international financial markets

In this model, it is assumed that the central bank can intervene in the foreign exchange markets. These operations are carried out by making or absorbing domestic deposits from the wholesale banks (ΔDCB;t ) in exchange for foreign assets  ΔFCB;t ; FCB;t is the central bank’s stock of international reserves, hence a reduction is equivalent to an increase in outflows. In each period, the central bank receives an interest on its foreign reserves R*t1 FCB;t1 and pays Rt1 Dt1 for the domestic currency denominated deposits held in the local financial sector. In this case, similarly to Benes et al. (2015), the profit or loss ðΓ CB;t Þ from central bank operations is transferred to households, as follows:

The model assumes that loans are created by wholesale banks, primarily by drawing on household deposits. Domestic funds can be supplemented by attracting resources from abroad, at an interest rate adjusted by a country-risk premium. The aggregated budget constraint is: LD;t ðjÞ þ St LF;t ðjÞ þ DCB;t ¼ Dt ðjÞ þ St LIB* ;t ðjÞ þ ΓK;t

(10)

where ΓK;t is the value of physical capital retrieved from defaulting entrepreneurs, St is the nominal exchange rate and Dt are household deposits. A variable of interest from wholesale banks’ budget constraint is DCB;t , which reflects central bank intervention, the mechanics of which will be discussed in Section 2.3. As for some caveats, Equation (10) assumes that the financing sources are perfectly substitutable, which is not empirically feasible since prudential regulators take into account the ratio between deposits and loans when evaluating the soundness of financial institutions. Furthermore, unlikely to be seen in practice is the unhedged wholesale bank exposure to currency risk, as, theoretically, domestic and foreign currency loans can be created using only domestic funds. Nonetheless, as the framework does not feature bank defaults (which is the main concern of the prudential authorities when imposing such regulations), the effects of currency risk in this regard are, to some extent, negligible. Another emerging-economy oriented modelling assumption regards the specification of a quadratic cost that kicks in when banks are changing their foreign exposure, which can further be interpreted as additional expenses associated with foreign borrowing. The presence of such a cost is backed by research carried out using micro level data (Philippon, 2015), where access to funding comes at additional costs, apart from the interest rate alone. φIB* ;t ¼

κIB* 2



LIB* ;t ðjÞ  π* LIB* ;t1 ðjÞ

Γ CB;t ¼ St R*t1 FCB;t1  St FCB;t  DCB;t þ Rt1 DCB;t1

(11)

Choosing an optimal level for foreign debt results in a slightly modified uncovered interest rate parity (in real terms):

Rt ¼ E t

(14)

The central bank resorts to the balance sheet effects for the success of the intervention. Therefore, it is assumed that in the international markets there are financial intermediaries that are willing to lend funds to economies, in exchange for a risk premium (which can be associated with a limited risk-bearing capacity), subject to a resource constraint linked to their loan portfolio composition. Since the portfolios of international financers include multiple assets, each one with its associated risk premium, the substitution among them is imperfect. For illustration purposes, let us consider a country that has borrowed from the international financial market is affected by an unfavourable shock. At this point, foreign investors (who have long positions with respect to the country) have to be compensated for the higher risk. In time, they will seek to get rid of the riskier assets, since it may affect their future stream of risk-adjusted profits. As such, once the financers start to reduce their exposure to the riskier assets, the level of perceived risk also diminishes. Likewise, the price of the currency decreases (i.e. it depreciates versus other currencies). From the perspective of the borrowing economy, this process triggers macro adjustments that could have an important impact on the economic environment. These prospective effects prompt central banks to intervene by placing foreign deposits on the foreign financial market (which is equivalent to a decrease in foreign reserves FCB;t ). The sterilisation

2 LIB* ;t

(13)



*  *



  ΛH;tþ1 π *tþ1 π *tþ1 lIB* ;tþ1 π lIB* ;t π t lIB* ;t lIB* ;tþ1 2 qtþ1 π tþ1  π* þ κIB* βH  π* R*t φRP;t þ κ IB* t * lIB* ;t1 lIB* ;t1 ΛH;t lIB* ;t lIB* ;t qt π tþ1

(12)

operation generates an increase in the available supply of local currency in the local banking sector (DCB;t expands). Put together, these actions are able to influence the relation between demand and supply of local currency in the foreign exchange market, which takes some pressure off the

where lIB* ;t is the deflated level of foreign borrowing, κ IB* is the curvature of quadratic loss function, βH is the households’ discount factor, π * steady-state foreign inflation, ΛH;t is the households’ budget constraint

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exchange rates. Concisely, the disturbance of economy-wide risk premium results in an abundance of local currency in the foreign exchange market, which is mitigated by the central bank by selling foreign assets from its international reserves. The local currency generated by the operation is passed through to the local banking sector in order to have a neutral effect on the money supply and, consequently, on the local interest rate (i.e. the exchange rate intervention is sterilised). For simplicity reasons, it is considered that the central bank oversees the foreign exchange market and is able to intervene swiftly, without additional costs and barriers if it considers that the exchange rate is misaligned. In fact, the central bank exploits the shallowness of the foreign exchange market, which in general is a feature of emerging economies (Calvo and Reinhart, 2002; Menkhoff, 2013). One should note that, in order for this mechanism to work, the central bank has to have important international reserves, and in the event the funds run out, the country can receive emergency liquidity from international financial institutions. In addition, the shocks that affect the economy have to spread in both directions in order for the central bank to preserve to some extent the level of foreign reserves over the medium term.

WEF;t ¼ Et

WED;t ¼ Et

(17)

  ðcD;tþs  hd cD;t1þs Þ1σD 1  σD

(18)

βsD εCE;tþs

Wt ¼ ð1  βH Þ WH;t þ ð1  βD ÞηL WED;t þ ð1  βF Þð1  ηL ÞWEF;t

(19)

Similarly to Ascari and Ropele (2012), the welfare gains or losses are reported in consumption equivalence units. Practically, this indicator measures the amount of consumption units that agents should give up in each period in order to obtain a similar consumption stream if the alternative economic events did not occur (or in case of policy scenarios, the ones that have not been implemented yet). Therefore, a negative value signals a welfare loss. Intuitively, such an event occurs when a shock creates deviations vis- a-vis the equilibrium path of the welfare-related variables. As such, the ranking between different policy regimes is given be the amount of their successfulness in mitigating this volatility and, therefore, keeping the deviations from equilibrium at a minimum. As for the policy rules, during simulations the following general representation for foreign exchange interventions is considered:

þ St P*t YM;t ΔM;t þ St P*t YIM;t ΔIM;t (15)

1ρF

FCB;t ¼ F CB

The equation reflects the flow of foreign borrowing St LIB* ;t  φRP;t1 R*t1 St LIB* ;t1 ,

the amount of exports PX;t St YX;t which are in domestic currency (local currency pricing is assumed, therefore exporters’ marginal cost is expressed in the currency of the country of destination). St P*t YM;t ΔM;t is the amount of imports (used for manufacturing final local consumption goods) and St P*t YIM;t ΔIM;t are re-exports (used for producing export goods), both of which were corrected for quantity losses occurred in the context of Calvo pricing. St P*t is the marginal costs of both types of imported goods. St φIB* ;t1 are the costs connected with foreign borrowings. Finally, the central bank interventions in the foreign exchange market are reflected in the balance of payments: R*t1 St FCB;t1 are the gross income from last period placements of foreign reserves and St FCB;t are the current reserves placed in the international foreign markets, both expressed in local currency.

ρ

F F CB;t1

γFq

γFΔq qt qt þ εF;t q qt1

(20)

where γ Fq is the response to real exchange misalignment and γ FΔq is the coefficient that modulates the response to one period change in real exchange rates (during the estimation process the values of these parameters are set at zero). ρF is the autoregressive coefficient and F CB is the steady-state level of the central bank’s holdings of foreign assets. εF;t is a standard white noise process. The monetary policy is conducted using a standard Taylor rule:  γπ γY γMq 1γR π C;t yt qt R Rt ¼ Rγt1 R þ εR;t πC y q

(21)

where γ R is the central bank preference for the degree of interest rate smoothing, γ π is the response to consumer price inflation π C;t deviation from the target π C ; γ Y is the feedback coefficient for the output gap and γ Mq is the response coefficient to exchange rate misalignment (during

2.5. Welfare definitions and policy rules

estimations it is assumed to be zero). R is the equilibrium level of the nominal interest rate and εR;t is a standard white noise disturbance.

7

This section presents the welfare definitions used in this paper. Based on common practice in the literature when dealing with large DSGE models (Clerc et al., 2015; Lambertini et al., 2013; Quint and Rabanal, 2014), welfare is derived by taking the second-order approximation of model equations. The individual agents’ welfare is defined as follows:

s¼0

  ðcF;tþs  hF cF;t1þs Þ1σ F 1  σF

where β’s are the discount factors, σ ’s are the intertemporal elasticities of substitution, h’s are the habit formation parameters, c’s are the consumption levels, εC;tþs and εCE;tþs are consumer preference shocks, εn;t affects households preference for working and ΔW;t is wage dispersion. An is a scaling factor used in order to ensure that labour hours do not exceed one third of available time in equilibrium. The aggregated consumer welfare is8:

St LIB* ;t þ R*t1 St FCB;t1 þ PX;t St YX;t ¼ St FCB;t þ φRP;t1 R*t1 St LIB* ;t1


X ∞


X ∞ s¼0

After listing the agents in an economy, one remaining concern regards closing-up of the model – this is done by adding up all constraints of the model. The resulting equation can be interpreted as the balance of payments of the economy expressed in local currency:

WH;t ¼ Et

βsF εCE;tþs

s¼0

2.4. The economy-wide resource constraint

þ St φIB* ;t1


X ∞

3. The calibration and the estimation process The following section presents some key elements of the calibration process, alongside relevant estimation results. The model is estimated (using Bayesian methodology) based on time series for the Romanian economy (located in Eastern Europe, member of the European Union) which features a fully open financial account. Moreover, the public

  ðcH;tþs  hH CH;t1þs Þ1σH ðΔW;tþs ntþs Þ1þσn βsH εC;tþs  εn;t An 1  σH 1 þ σn (16)

8

In the model used in this paper, entrepreneurs maximize future consumption (in contrast to the Bernanke et al., 1999 framework where the entrepreneurs are profit maximizers, hence they are risk neutral). Therefore, their level of consumption is affected by the source of stochastic volatility (see Faia and Monacelli, 2007 for a more detailed discussion).

7 The welfare function for each agent is evaluated given the conditional expectation of the lifetime utility with respect to a reference period t.

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acknowledgment by the National Bank of Romania9 (NBR) that it uses foreign exchange interventions in order to smooth out the trajectory of the exchange rate qualifies the economy as a good subject for testing the research questions. In addition, the economy presents a high level of loans denominated in foreign currency, even though it has receded in the aftermath of the crisis. The major benefit of the estimation is the fact that the entire stochastic environment is estimated (rather than calibrated), which, to some extent, brings the results emphasised in this paper more closely to the real shocks encountered by policymakers. As otherwise specified, the selected steady-state values reported from this point forward are based on actual data, the average for the period 2010–2018, a time spam which is considered to be homogenous in terms of the structure of the economy. Given the fact that the estimation procedures of DSGE models is beyond the scope of this paper, the process is briefly described – the complete list of calibrated parameters, along with estimated parameters, is available upon request. As argued in the previous section, the central bank’s ability to influence the risk premium relies heavily on the responsiveness of the latter variable to economic fundamentals. In literature, most of the papers specify the elasticity of the sovereign risk premium with respect to debt at very small values (typically around 0.01) with the main scope of ensuring stationarity of the model10. On the other hand, however, the papers that look at the effectiveness of foreign exchange interventions tend to favour a higher value for this coefficient.11 Likewise, the theoretical approaches used to model sterilised foreign exchange interventions assume, to some extent, a high responsiveness of the risk premium to economic fundamentals. Nevertheless, one possible solution to this issue would be to try to estimate this parameter along with other model parameters, but as pointed out by Brzoza-Brzezina and Kotłowski (2018), there is a need for additional control variables (like inflation rate differential, fiscal position) to pin down the value of this elasticity. Given this wide variety of possible values, this paper turns to empirical literature in order to infer a highly probable value for the elasticity of the sovereign risk premium with respect to the debt-to-GDP ratio. Aizenman et al. (2013) estimate an increase by 7.9 basis points of the risk premium (measured by Credit Default Swaps spreads) after a 1 percentage point rise in the foreign debt – the result is based on panel data estimations with 50 countries. A similar value (7.4 basis points) is put forward by De Grauwe and Ji (2013), when focusing only on euro area countries, while Ciarlone et al. (2009), estimate an elasticity of 6.3 basis points for Bulgaria. Keeping in mind these estimates, the elasticity of the risk premium with respect to foreign debt is calibrated at 0.072, which basically mirrors a 7.2 basis point increase in the risk premium (which is the average of the previous mentioned elasticities) when the foreign debt-to-GDP ratio goes up by one percentage point. Moving to the curvature parameter of the quadratic costs function attached to the foreign borrowing activities, the value was set at κ IB* ¼ 0:02, which is in line with a 2 percent cost of financial intermediation, as estimated by Philippon (2015), using firm level data. Turning to inflation, the annual steady-state value is set at 2.5 percent, which is the central point of the NBR’s targeting interval. Next, the household discount factor is calibrated at 0.9972, implying a value of 3.42 percent for the nominal annual interest rate – which mimics the average 3-month interbank rate (ROBOR). As for the foreign variables, the steady-state inflation rate is set at 2 percent per annum and the interbank interest rate (3M EURIBOR) is set at 0.25 percent. Given these

calibrations of inflation and interest rates, the steady-state value for the risk-premium is 265 basis points (see UIP condition, Equation (12)). The interest rates on domestic and foreign currency loans are set at 8.16 percent and 4.27 percent, respectively, mirroring the interest rates (excluding other financing costs) charged by banks on new loans from 2010 to 2018. Proceeding with entrepreneurs’ calibrations, the discount factor was set at 0.945 for both types. With respect to loans, the targeted steadystate ratio to GDP is 0.43 (based on data provided by the Credit Register), of which 0.18 points is attributed to domestic currency denominated loans. In order to facilitate the replication of these data moments in the steady state of the model the monitoring cost was set at 0.39 for both types of entrepreneurs. At a first glance, this value seems to be particularly high, however, it is supported by the low debt recovery rate12 (once a firm enters insolvency proceedings) which characterises the Romanian economy. The steady state cut-off value of the idiosyncratic quality shock was set at 0.58 for DCL and at 0.44 for FCL entrepreneurs, respectively. Under these circumstances, the entrepreneurs’ weighted probability of default implied by the model is 6.94 percent, which is similar to the endof-period average share of non-performing loans in 2016–2018. The loan-to-value for domestic currency-denominated loans is 0.36 and 0.44 for foreign currency loans. As for the macro variables, the target share of the consumption to GDP ratio is 0.63. The investment share in GDP was set at 0.20 (mirroring the average share of private capital investment in GDP, as reflected by the European Commission’s AMECO database) by setting the depreciation rate at 17 percent per annum and the share of capital in the production function at 0.5. The weight of imported goods in the total consumption basket was set at 50 percent, which is supported by NBR estimates.13 As for re-exports, the weight is set at 0.28, as in Copaciu et al. (2016), which is in line with OECD data on the share of foreign value added embedded in Romania’s total exports. The share of external debt in annual GDP was calibrated at 24 percent, i.e. the outstanding level of foreign loans taken by the private sector (data available only from 2012), whereas the share of the NBR’s foreign reserves (excluding gold and SDRs) in annual GDP was set at 0.21, replicating data averages from 2010 to 2018. Selected key model steady-state ratios are set out in Table 1. The model is estimated by using the Bayesian methodology proposed by An and Schorfheide, 2007. The estimation dataset is composed of 19 time series, spanning from 2002 Q1 to 2018 Q4 (68 observations), including national accounts series taken from Eurostat such as the GDP, household consumption, gross fixed capital formation and the exports of goods, all of them at constant prices. In addition, the quarterly growth rates of GDP deflator and import deflator are included. The remaining real-economy variables, which were taken from the Romanian National Institute of Statistics, are CORE inflation rate (excluding VAT rate changes, estimates made by the NBR), average net wages of the private sector and manufacturing producer prices’ inflation rate. The real exchange rate, calculated using manufacturing producer prices in relation to 38 export partners was provided by ECB’s data warehouse. The data referring to the euro area GDP, inflation (excluding energy, at constant taxes) and interest rates were taken from the Eurostat database. Data concerning the financial variables were taken from the National Bank of Romania database and refer to the private sector’s outstanding loans denominated in RON and foreign currencies (taken from the Credit Register), to the interest rates on new loans expressed in RON and EUR (the series are available only from 2007, past values being filled based on

9

12 The World Bank’s Doing Business indicators suggest an average recovery rate of 33.5 percent (from 2010 to 2019) for Romania, whereas in the case of welldeveloped economies the repossessed collateral from borrowers who enter insolvency accounts for around 90 percent of the exposure. 13 See Box 2 entitled The relationship between economic activity and inflation in the NBR’s Inflation Report, May 2017, available at http://www.bnr.ro/Documen tInformation.aspx?idDocument¼25035&idInfoClass¼6876.

See Is
arescu, 2019. In this respect, see Brzoza-Brzezina and Makarski (2011); Fernandez and Gulan (2015). 11 For instance, Faltermeier et al. (2017) use a value of 0.4, arguing that it matches a current account increase of 0.4 percentage points of GDP, when central bank foreign reserves expand by one percent, elasticity which is provided by the empirical literature. 10

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Table 1 Selected model steady-state ratios – comparison with actual data.

Consumption (% of GDP) Entrepreneurs’ consumption (% of GDP) Households’ consumption (% of GDP) Private investment (% of GDP) Exports (% of GDP) Imports (% of GDP) Capital stock (% of GDP) 3M ROBOR (%, annual) Interest rate on domestic currency-denominated loans (%, annual) Interest rate on foreign currency-denominated loans (%, annual) Loans*, outstanding (% of GDP) Domestic currency-denominated loans (% of GDP) Foreign currency-denominated loans (% of GDP) Loan default rate, NPL (%) Defaults on domestic currency-denominated loans Defaults on foreign currency-denominated loans Loan-to-value (to capital holdings) Loan-to-value domestic currency-denominated loans Loan-to-value foreign currency-denominated loans External loans - private sector (% of GDP) NBR reserves, excl. gold and SDRs (% of GDP)

Table 2 Structural shock estimates.

Model

Data

0.63 0.20 0.43 0.19 0.37 0.42 1.12 3.42 8.16 4.27 0.43 0.18 0.25 6.94 8.27 5.87 0.41 0.36 0.44 0.24 0.21

0.63 – – 0.20 0.39 0.42 – 3.42 8.16 4.27 0.43 0.18 0.25 7.00 – – – – – 0.24 0.21

Standard deviation of shocks

Prior Distribution type

mean

std

Mean

5%

95%

Productivity

inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ inv. Γ

0.010

0.10

0.0154

0.0132

0.0176

0.010

0.10

0.4695

0.1671

0.7990

0.010

0.10

0.3382

0.2778

0.3987

0.010

0.10

0.7220

0.5982

0.8506

0.010

0.01

0.0463

0.0397

0.0531

0.010

0.10

0.0176

0.0147

0.0205

0.010

0.10

0.0496

0.0419

0.0573

0.010

0.10

0.0436

0.0357

0.0512

0.010

0.10

0.5988

0.3806

0.8002

0.001

0.01

0.0113

0.0084

0.0141

0.010

0.10

0.1327

0.1092

0.1541

0.010

0.10

0.2851

0.2166

0.3502

0.001

0.01

0.0023

0.0020

0.0026

0.001

0.01

0.0035

0.0030

0.0039

0.001

0.01

0.0034

0.0028

0.0040

0.001

0.01

0.0653

0.0560

0.0746

0.010

0.10

0.0072

0.0062

0.0082

0.001

0.01

0.0013

0.0011

0.0015

0.001

0.01

0.0009

0.0007

0.0010

Labour preference Consumption preference – households Consumption preference – entrepreneurs Government consumption Mark-up for domestic prices Mark-up for export prices Mark-up for import prices Mark-up for re-export prices Risk premium Quality shock - domestic entrepreneurs Quality shock - foreign entrepreneurs Mark-up for domestic interest rates Mark-up for foreign interest rates Monetary policy shock

Notes: Actual data were taken from Eurostat and NBR websites. Data ratios refer to sample average from 2010 to 2018, excluding external loans, for which the series starts in 2012, and the share of non-performing loans, end of period average for 2016–2018. *) The total amount of loans granted by credit institutions (annual average).

the data available in the NBR’s Monthly Bulletins), to the 3M interbank rate (3M ROBOR) and to the outstanding level of foreign debt. In order to match observables with model variables, the trend was extracted using an OLS estimate for the quadratic trend. Next, the prior distributions and some key estimation results are presented. Starting with habit formation, the prior was set at 0.5 with a standard deviation of 0.05 for all the agents. The posterior estimate sits around 0.40, which is in line with the value reported by Nalban (2018). For price and wage rigidities, a period of two quarters was assumed between domestic and export price re-optimisations, whereas the period between import prices and wages was extended to three quarters. The estimation suggests a lower relevance of these nominal rigidities, as the average duration of the wage contract is less than two quarters and the period between price re-optimisations is around one-and-a-half quarters in the case of domestic and import prices and one quarter for export prices. Although these values seem to be low in comparison with estimates for advanced economies (see, inter alia, Razafindrabe, 2016), there is survey-based evidence that supports these findings (see Copaciu et al., 2010; Iordache and Pandioniu, 2015). Concerning the autoregressive coefficients of the structural shocks, apart from the mark-up shocks where the mean was uniformly set at 0.8, for the remaining parameters, the mean was set at 0.7 with a standard deviation of 0.1. The estimation reveals a high persistence (above 0.8) for the mark-up shocks, risk premium shock, entrepreneurs’ capital quality shocks and for the productivity shock, whereas for consumption preferences the estimated inertia is below 0.7. As for the standard deviation of shocks, the prior mean was set at 0.01, apart from the shocks that are expressed in percentages (interest rates and mark-ups), where the mean is 0.001. The estimated values for the structural shocks are set out in Table 2.

Foreign exchange interventions Foreign demand Foreign inflation Foreign interest rates

Posterior distribution

Note: Results based on Metropolis-Hastings sampling with two Markov-chains and 500,000 replications per chain, with an average acceptance ratio of 28%.

in the model set-up used in this paper, where the two mechanisms in place that erode its boosting effect on aggregate production. The first one refers to the fact that export goods have to incorporate foreign-made inputs. This characteristic has the following direct implication: it erodes local production by a factor of ð1  ηX Þ– which is the weight of imported goods in the aggregated exported goods – and increases aggregate imports. The strength of this channel is inversely related to the amount of domestic value added14 embedded in exports (value approximated by ηX ), as a smaller share of the latter decreases the sensitivity of exporters to exchange rate fluctuations. The second mechanism refers to the presence of foreign currency loans. In this respect, currency depreciation affects the debt-servicing capabilities of foreign currency-indebted agents, depressing their consumption levels. The strength of this channel naturally depends on the relative importance of foreign currency denominated loans in total loan portfolio. A high relevance for this type of loans is observed in Central and Eastern European (CEE) economies, even if, as in the case of

4. The relevance of foreign currency loans

14

For Romania’s economy, this share of domestic value added embedded in gross exports is among the highest when compared to its peers in the CEE region (around 78 percent in 2016, according to OECD data). This share is around 55 percent in the case of Hungary and Slovakia, slightly above 60 percent in Czechia and around 72 percent in Poland.

As emphasised by the UIP condition (Equation (12)), a risk premium shock will cause the currency to depreciate, since the exchange rate can adjust quickly in order to restore external equilibrium. In small open economy models, this movement usually boosts exports, as foreign agents show a higher interest in locally manufactured products that become cheaper due to a weaker local currency. The trade channel prevails even 8

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Fig. 1. Different shares of foreign currency loans - response to shocks. Notes: OY - percent deviation from steady state (the inflation rate is in percentage points deviation from equilibrium); OX - period in quarters. The model is disturbed with one estimated standard deviation for each shock. EEs refers to entrepreneurs. The inflation rate is annualised.

Romania, the importance of foreign currency loans15 in banks’ total loan portfolio (to households and non-financial corporations) has receded of late. In this context, it is worth taking a closer look at the adjustment process after the economy is affected by a shock, with respect to various strengths for the wealth channel. More precisely, the model is simulated with a very low level of foreign currency loans (the share of entrepreneurs that borrow in domestic funds is ηL ¼ 0:99) and with a high level thereof (ηL ¼ 0:01), respectively. The results are presented in Fig. 1. An exogenous increase in the risk premium (the estimated standard deviation is around 0.01) causes the local currency to depreciate, boosting exports and resulting in an expansion of the economy. However, the depreciation of the currency increases the price of imported goods. Faced with higher inflation (and output), the central bank reacts by raising the nominal interest rate (the feedback coefficient to inflation is estimated at 2.6), leading to a moderation in consumption and investment. Furthermore, on the back of currency depreciation, foreign entrepreneurs’ debt (in domestic prices) goes up, causing them to adjust more markedly downwards their levels of consumption and investment, compared with domestic entrepreneurs. Therefore, when the relative importance of the former type increases, aggregate consumption (and investment) will post a sharper decline. Nonetheless, the presence of the

wealth channel16 is not able to fully offset the expansion of production, one reason being the relatively small calibration of the loans-to-GDP ratio.17 Next, when the economy witnesses a temporary increase in productivity, the cash flow of foreign entrepreneurs improves in comparison with local entrepreneurs, since the currency appreciation reduces their debt service, allowing them to consume and invest more. As such, the economy grows faster and over a longer period. Nevertheless, when the appreciation of the currency is ascribable to a temporary loss in price competitiveness (approximated by higher mark-up of export prices), the economy trails for a longer period below potential if the share of foreign currency loans is very high. This is a consequence of diminished efficacy of monetary policy in affecting the output, since the reduction in domestic nominal interest rates (entailed by the drop in output and inflation) affects to a lesser extent the activity of FCL indebted agents. This fact is further emphasised by the last group of charts (panel D) in Fig. 1, showing that for a similar monetary policy impulse, output drops less when the share of foreign currency loans is very high.

16

In other simulations (not presented in the paper) that featured a higher importance of the financial intermediation and with a similar structure of lending currencies, after a very short-lived upswing in production, the economy entered in a longer recession. 17 In other CEE countries (Poland, Czechia or Bulgaria), the importance of financial intermediation is significantly higher than the value observed in Romania, which means that, for the specified countries, this channel may be stronger.

15 According to the ECB’s Statistical Data Warehouse, in Poland and Hungary for example, foreign currency loans still account for more than 20 percent of the loan portfolio in 2018, whereas in Croatia this share is more than 55 percent.

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Fig. 2. Agents’ welfare with respect to different shares of domestic currency loans. Notes: These figures present conditional agents’ welfare expressed in consumption equivalent units with respect to the baseline scenario (where all loans are denominated in domestic currency). DCL and FCL entrepreneurs refer to those who take loans denominated in domestic and foreign currency, respectively.

currency loans generates social welfare losses, a matter of increased importance being the heterogeneity observed among agents, which creates important trade-offs for policy-makers.

A relevant policy question refers to the impact of a larger stock of foreign currency loans on consumer welfare. In this regard, Fig. 2 illustrates the individual agents’ welfare gains or losses with respect to an external financial shock (Fig. 2A) and the entire stochastic environment, excluding policy related shocks (Fig. 2B). Therefore, in the event of a foreign financial shock (approximated by an increase in sovereign risk premium), a large share of foreign currency loans brings about lower social welfare. In this respect, agents are willing to give up at most 0.03 percent of lifetime consumption in order to find themselves in the case where all loans are granted in domestic currency – a similar result is also shared by Brzoza-Brzezina et al. (2017). Entrepreneurs generate the social welfare losses encountered at the aggregated level, with a larger contribution from those who borrow in domestic currency. In this case, the lifetime consumption stream is affected by higher exchange rate volatility, on the back of a more active monetary policy (given its weaker efficiency); due to the nature of the shock, exchange rate and interest rate volatility move in the same direction. As agents become better protected against currency risk, welfare losses are smaller. As such, entrepreneurs who prefer FCL would give up around 0.01 percent of lifetime consumption, compared with 0.05 percent, in the case of entrepreneurs that borrow only in domestic currency. One should note that, a higher exchange rate volatility depresses entrepreneurs’ welfare (due to its direct effects on external sales), whereas in the case of nominal interest rates a higher volatility improves welfare (the variations of output and inflation are lower). From a broader perspective, revealed by all model shocks, the overall welfare losses of a higher stock of foreign currency loans are particularly small. However, such an outcome is the net result from the welfare losses of households (of around 1 percent of lifetime consumption) and the gains spotted for the entrepreneurs; those exposed to FCL display even a higher welfare gain. Looking more into detail, the entrepreneurs’ preference for foreign currency loans is positively associated with the fact that in the context of all model shocks (where supply shock prevails) and comparatively to the benchmark (of no FCL), exchange rate movements are smaller, helping external incomes to stabilise. This evolution is attributable to the monetary-policy efficacy losses, as the interest rate capability to stimulate the economy via the credit channel decreases. Consequently, monetary takes on a more active stance (which results in a larger response via interest rates) which in turn stabilise the exchange rates better (this relation will be further explored in the following sections). In other words, in the context of supply shocks, for the same level of interest rates, when the share of FCL increases, the variations of local variables (output and inflation) is wider, entailing a shift of welfare gains from households to entrepreneurs. To conclude, when the economy is characterised by a large share of foreign currency, monetary policy has to be more responsive in order to achieve a similar outcome in terms of economic stabilisation, as it is addressing a smaller population share. Likewise, the presence of foreign

5. Mechanics and welfare implications of sterilised foreign exchange interventions After exploring the macroeconomic effects of a large stock of foreign currency loans, the following section investigates the possibility of using foreign exchange interventions as an additional policy instrument.

5.1. The implementation of foreign exchange interventions For a better illustration of the mechanism whereby foreign exchange interventions affect the economy, three additional policy designs are considered apart from the baseline, which features a standard Taylor rule. Therefore, the first regime assumes that the central bank takes into account real exchange rate movements when setting the interest rate (referred to as Taylor-NX regime), while in the second one, the monetary authority responds softly ðγ Fq ¼ 3Þ to real exchange rate deviation from fundamentals, seeking also not to hasten the adjustment process (γ FΔq ¼ 3Þ – the “FX-soft” regime. In the last one, the exchange rate is managed harder (the “FX-hard” regime), the feedback coefficient in both cases being set at 10 (see Equations (20) and (21)). The results of simulations, after a risk premium and an export price mark-up shock, are presented in Fig. 3. An event that affects the risk premium of the economy results in the depreciation of the local currency. Delving further into the theoretical mechanism, the depreciation is the effect of a temporary disequilibrium in the foreign exchange market, since, in the context of higher risk, the international financial intermediaries reduce their exposure to the local currency. Faced with this disequilibrium, the central bank intervenes by supplying foreign currency funds (which are deposited with the foreign financial system), the reverse operation requiring the passing out of excess of local currency from the foreign exchange market to domestic banks. These operations reduce the amount of local securities on the financial intermediaries’ balance sheet. Therefore, as their risk-adjusted portfolio recovers to the initial level, the desire to sell local assets decreases, causing a rebound in the risk premium. As such, when the central bank intervenes in the foreign exchange markets, upon the impact, a risk premium shock has a smaller expansionary contribution to output, given the lower depreciation of the currency, which means exports are growing at a slower pace. In addition, exchange rate management takes some pressure off the monetary policy since on the back of softer output increase, the inflation has a more subdued trajectory. Another contribution comes from imported inflation, where the smaller depreciation of the local currency does not entail high 10

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Fig. 3. Managing the exchange rates – various strategies. Notes: OY - percent deviation from steady state (inflation and interest rates are in percentage points deviation from equilibrium); OX - period in quarters. The model is disturbed by one estimated standard deviation for each shock. Taylor-NX refers to the scenario where the central bank takes into consideration the real exchange rate deviations from equilibrium when setting interest rates via a Taylor rule: the value for the feedback coefficient is set at γMq ¼ 1. FXsoft regime considers that the monetary authority performs a soft exchange rate management (feedback coefficient is γFq ¼ 3 and γFΔq ¼  3). FX-hard assumes that the central bank’s response to exchange rate misalignment via the intervention rule is much firmer. The feedback coefficients are set at 10.

remaining agents the improvements are less obvious. As suggested previously, in this instance, the foreign exchange interventions are very powerful in terms of economic stabilisation, the main reason being the fact that the exchange rate movement, stemming from financial sources, can easily be offset by the central bank via foreign exchange interventions that manage the supply of local currency in the foreign exchange market. Likewise, effectiveness is supported by the fact that an external financial shock (either in the form of risk premium or foreign monetary policy) is not the result of domestic structural weaknesses. However, when the real exchange rate misalignment can be attributed to domestic mark-up increases, a trade-off kicks in, as the central bank’s foreign exchange interventions may hurt those agents that are not directly tied to exchange rate fluctuations (similarly to other findings in literature; see, for instance, Benes et al., 2015). This occurs primarily because there is a trade-off between stabilising the exchange rate and preserving low volatility of domestic variables, particularly visible when the price competitiveness of the economy is affected. One way to interpret these developments is that foreign exchange interventions delay the adjustments of the economy that are needed to cope with the price competitiveness losses. Entrepreneurs are those agents who benefit most in terms of welfare from the exchange rate management, as their future consumption stream is affected by exchange rate volatility. In the case of entrepreneurs exposed to FCL, the variance of the exchange rate is more important since it has additional implications in terms of financial wealth (via the financial accelerator mechanism). Turning to households, the foreign exchange intervention following a mark-up shock reduces the need for monetary policy intervention (a lower depreciation means a smaller drop in inflation), which contributes to a larger volatility of household consumption. Therefore, they witness important welfare losses as a result of the central bank’s foreign exchange interventions.

local price increases. The softer response from the monetary policy helps consumption and investment to perform better. Likewise, the external equilibrium of the economy can be affected by developments in the terms of trade. For example, an increase in exporters’ prices (due to higher mark-ups charged by retailers) entails, as expected, a fall in foreign demand, which pushes both output and inflation below equilibrium. Under these circumstances, the monetary policy reacts by lowering the nominal interest rate (to prop up consumption and investment), which fuels depreciation pressures as the interest rate differential with respect to foreign economies narrows. The latter development helps exports to recover. However, a softer currency triggers a foreign exchange intervention which calms down the real exchange rate movements. As such, the positive effect of a softer currency on exports fades away, entailing a longer recession. Basically, in this situation, the foreign exchange intervention nullifies the monetary policy effects on output and inflation dynamics. Moreover, the cost in terms of central bank’s foreign reserves is very high, since due to the important persistence of the export price mark-up shock (estimated at around 0.9), the real exchange rate stays for a prolonged period above the equilibrium level. A mirror image emerges when the import price mark-up increases, since in order to address the currency appreciation, the central bank builds up a large amount of reserves, without important gains for the stabilisation of the economy. Fig. 4 shows agents’ welfare with respect to the central bank’s response to exchange rate movements after a risk premium and price mark-up shocks. In the case of the former, managing the exchange rate generates social welfare gains without any visible trade-offs in terms of individuals’ well-being. As expected, the main recipients are those agents that are exposed to exchange rate risk – their welfare gains are above 0.2 percent of the lifetime consumption (when the central bank’s response to exchange rate misalignment is the largest), whereas in the case of the 11

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Fig. 4. Agents’ welfare with respect to the response to exchange rate misalignment. Notes: These figures show conditional agents’ welfare expressed in consumption equivalent losses or gains with respect to the baseline scenario (where the central bank does not intervene in the foreign exchange market), after a risk premium shock and price mark-up shocks, respectively. The foreign exchange intervention rule considers the deviation from fundamentals and the speed of adjustment of the real exchange rate. DCL and FCL entrepreneurs refer to those who take loans denominated in domestic and foreign currency, respectively.

5.2. Optimal policy rules – monetary policy and foreign exchange interventions

maximisation is carried out with respect to each group. The simulations show that, regardless of which policy set-up is considered, when it comes to maximising the aggregated welfare of all agents, the optimal response to inflation (from the Taylor rule) is at the lower bound (of 1.5) and the one for the output gap stands at 0.5718. These results are also shared by other papers that focus on the optimal monetary policy in small open economies,19 since in this type of environment, when there is an imperfect pass-through of the exchange rate onto domestic prices, the central bank would care less about stabilising prices and more about exchange rate volatility. Turning to the main questions of this section, compared to the benchmark policy, it seems that the introduction of real exchange rate in the Taylor rule improves consumer welfare (Table 3, column 2), on the back of higher welfare gains observed at the entrepreneurs who take FCL. As monetary policy tries to restore equilibrium in both money and foreign exchange markets, the response of the nominal interest rate is softer (allowing for higher volatility of inflation and output), thereby affecting the volatility of households’ and domestic entrepreneurs’ consumption. In the latter case, the credit channel supplements welfare losses, because a higher volatility of inflation affects repayable debt, as the loan contract is in nominal terms. Furthermore, this exercise also reveals that managing the exchange rate using a stand-alone instrument has benefits in terms of consumer welfare. Undoubtedly, the most important gains are reported for the entrepreneurs that borrow in foreign currency, especially when the central bank intervenes in the foreign exchange market considering only relative price developments (in this case, the welfare gains are around 3.2 percent of lifetime consumption). Likewise, the other type entrepreneurs benefit from a more stable exchange rate, their preference being also for the rule considering real exchange rate developments alone. In this respect, both types of agents tend to dislike excessive smoothing of foreign exchange interventions, one possible explanation being that this policy framework is not flexible enough to successfully cope with a string of adverse shocks, especially when the monetary policy response is mild. Indeed, in order for the high smoothing of foreign exchange interventions to deliver better results in terms of overall consumer welfare, monetary policy has to be very aggressive in responding to inflation, as showed in Fig. 5. One way to view this finding is that possible losses

In the previous section, the welfare analysis was conditional on knowing precisely what type of shock hit the economy. Nonetheless, in most cases the origin of the disequilibrium can be difficult to pinpoint, which could pose some uncertainty with respect to the best policy action. As such, this section explores the optimal policy response conditional on all model shocks (less the policy-related ones), sticking to the assumption that both monetary and exchange rate policies are conducted according to the rules described by Equations (20) and (21) (this approach to optimal policy was pioneered by Schmitt-Grohe and Uribe, 2007). A mention should be made with respect to the steady state of the model. As the framework incorporates both nominal and financial frictions, the static equilibrium is distorted, case in which, without additional corrections (which are not undertaken), optimal policy can deliver only the second-best allocation of resources. Therefore, the strategy used to explore the optimal policy response resorts to implementing a search grid over a plausible set of values for policy parameters (this approach is frequently employed in literature for similar exercises – see, inter alia, Angelini et al., 2014; Faia and Monacelli, 2007; Lambertini et al., 2013). The analysis starts from the evaluation of the optimal monetary policy with respect to its response to inflation and output gap (which is the benchmark). The search grid for the response to inflation is defined over [1.5, 3.5] with 40 data points and the response to output gap is searched within a [0, 1.5] interval for a total of 30 values. Next, the Taylor rule is augmented by the real exchange rate, for which the optimal feedback parameter is searched over the [0, 2] interval with 30 values. As for the inertia of the policy instrument, during the simulations, it was assumed that the estimated value for the autoregressive coefficient in the Taylor rule (of 0.84) reflects the policy-makers’ preference as to how often it desires to change the policy rate. In the remaining scenarios, it is considered that the central bank’s toolkit is supplemented by a foreign exchange intervention rule targeting the real exchange rate. More precisely, the monetary authority looks at real exchange rate deviations from the equilibrium level (the parameters are searched between 0 and -10), also taking into account the growth rate and a high inertia for the interventions (ρF ¼ 0:97). The bounds of the search grid were chosen so as to reflect theoretical constraints and to avoid unnatural model behaviour. The result of this exercise in set out in Table 3, where columns (1) to (5) show the results associated with policy set-ups discussed above. Furthermore, the first set of results is conditional on the maximum agents’ welfare (this panel, apart from optimised coefficients, contains the welfare implications for each type of consumer and the volatility of some key variables), whereas in the latter three sets, the welfare

18 During welfare simulations, apart from the restrictions imposed by the search grid intervals, an additional constraint referred to the monetary policy response to output and real exchange rate gaps was put in place. This was needed in order to avoid unnatural volatility of model variables. As such, these response coefficients have to be 2.5 times smaller than the response to inflation. 19 See for example Faia and Monacelli (2008); Schmitt-Grohe and Uribe (2007).

12

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Table 3 Optimal policy response rules. Taylor rule

Taylor rule with RER gap

Taylor rule and exchange rate management – gap

Taylor rule and exchange rate management – gap and growth rate

Taylor rule and exchange rate management – smoothing and gap

(1)

(2)

(3)

(4)

(5)

1.50 0.57

1.50 0.57

1.50 0.57

–

–

–

10.00

10.00

2.76

–

10.00

–

–

–

0.97

0.069 0.158 0.924 0.640

0.123 0.141 3.157 1.646

1.081 1.635 2.746 0.351

0.0297 0.0276 0.0050 0.4996

0.0303 0.0282 0.0052 0.6813

0.0214 0.0175 0.0021 4.3770

1.50 0.00

1.50 0.00

1.50 0.00

–

–

–

0.69

0.34

10.00

–

0.34

–

– 0.026

– 0.017

0.97 ¡0.109

3.50 0.98

3.50 0.98

3.50 0.98

–

–

–

10.00

10.00

0.00

–

10.00

–

– 0.188

– 0.446

0.97 0.000

1.50

1.50

1.50

0.57

0.57

0.57

–

–

–

10.0

10.0

0.0

–

10.0

–

– 0.640

– 1.646

0.97 0.000

Target variable: Social welfare 1.50 1.50 Response to inflation - γ π Response to output gap 0.57 0.57 γY – 0.07 Response to RER gap (Taylor) - γ Mq – – Response to RER gap γ Fq – – Response to RER growth rate - γ FΔq – – Intervention inertia - ρF Welfare in consumption equivalent units Households – 0.283 Domestic entrepreneurs – 0.421 Foreign entrepreneurs – 0.907 Social welfare – 0.013 Standard deviations Inflation 0.0330 0.0347 Output 0.0287 0.0318 Real exchange rate 0.0103 0.0103 Foreign reserves – – Target group: Households Response to inflation - γ π 1.50 1.50 Response to output gap 0.00 0.00 γY – 0.00 Response to RER gap (Taylor) - γ Mq – – Response to RER gap γ Fq – – Response to RER growth rate - γ FΔq – – Intervention inertia - ρF Social welfare – 0.000 Target group: Domestic entrepreneurs Response to inflation - γ π 3.50 3.50 Response to output gap 0.98 0.93 γY – 0.07 Response to RER gap (Taylor) - γ Mq Response to RER gap – – γ Fq – – Response to RER growth rate - γ FΔq – – Intervention inertia - ρF Social welfare – ¡0.013 Target group: Foreign entrepreneurs Response to inflation 1.50 1.50 γπ 0.57 0.57 Response to output gap γY – 0.55 Response to RER gap (Taylor) - γ Mq – – Response to RER gap γ Fq – – Response to RER growth rate - γ FΔq – – Intervention inertia - ρF Social welfare – ¡2.381

Notes: The welfare is assessed conditional on all non-policy related shocks in the model. In order to deter any implausible variances of model variables, the coefficients with respect to the response to output and real exchange rate deviations from Taylor rule were restricted to be 2.5 times lower than the response to inflation.

respect, there is evidence suggesting that such a development increases the probability of currency crises (Holtem€ oller and Mallick, 2013). Turning to households, there is solid evidence that classifies foreign exchange interventions as being welfare decreasing (or in some cases having a weak impact on the agents’ well-being). Households’ major benefit with respect to a more stable exchange rate generally boils down to the retained profits channel (which includes those from the agents who produce the goods and the banking sector). Their welfare is more closely

associated with over-management of the exchange rate are mitigated by the monetary policy via the interest rate. Nonetheless, one should note that the costs in terms of reserves are very high when the central bank excessively smooths its interventions, as in this case foreign reserve volatility is six times larger than in the non-smoothing strategy. Besides the cost in terms of reserves, over-smoothing of foreign exchange interventions can decrease the flexibility of the currency regime, which in turn can determine a larger degree of exchange rate misalignment. In this 13

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the price of exports. The lower foreign demand has a negative impact on the local economic activity, pushing inflation below the steady state. The central bank reacts by cutting the interest rate, which weakens the currency. However, when the central bank mitigates the depreciation via the intervention, inflation is even lower (a currency depreciation has a positive impact on the consumer prices, via imported prices) which entails even a lower interest rate in order to boost local economic activity. Therefore, in this scenario, where the central bank intervenes in the foreign exchange market, the interest rate is much more volatile as a result of higher movements in inflation. 6. Concluding remarks Interventions in foreign exchange markets are an essential instrument in the central banks’ toolkit. However, there is little information with respect to welfare effects on various agent types. This paper, by employing a large-scale structural model with savers and borrowers in local and foreign currency, that allows the central bank to intervene in the foreign exchange market, investigates the welfare implications of such actions. The model allows therefore for the disentanglement of welfare effects by type of agent and source of exchange rate imbalance, which is novel in the literature, providing useful insight to central bankers. One case when foreign exchange interventions may prove highly effective (improving welfare regardless of agent type) is the situation when the incentive of foreign financial intermediaries to hold domestic assets decreases (as a result of changes in the risk premium of an economy), which leads to a depreciation of the currency. In this case, the central bank leans against the wind and takes out the excess supply of local currency from the foreign exchange market by selling foreign assets from its reserves, thereby influencing the actual movements of the exchange rate (and to some extent the expectations) – the interventions are sterilised by taking the excess local currency from the international markets to the domestic banking sector. As such, in this scenario, the central bank is not constrained to use solely the nominal interest rate. As a result, the consumption path of all agents is more stable, thus extending its present discounted value, with favourable effects on the social welfare. However, when exchange rate movements are driven by local nonfinancial factors, the central bank’s desire to mitigate exchange rate volatility entails significant costs. Take, for example, a shift in the competitiveness position of local enterprises, reflected by real exchange rate changes, if addressed by the central bank via interventions, it delays firm-level adjustments. In the alternative scenario, the movements of the exchange rate force producers to become more competitive, which stabilises the economy. Nonetheless, interventions under these conditions benefit consumers who are inherently exposed to exchange rate risk, triggering welfare losses for those tied chiefly to domestic developments. The inverse relation between volatility of the exchange rate and that of nominal interest rates that emerges in such a situation captures this tension. Overall, the effects of the exchange rate on the local economy are exacerbated in the model by the presence of loans granted in foreign currency. In such a setup, exchange rate movements have a direct impact on the borrowers’ balance sheet, since any movement can affect their debt-servicing capabilities. However, when the share of foreign currency loans widens, the efficacy of the monetary policy to influence the local economy diminishes. In this respect, let us assume that non-residents’ demand for domestic assets rises. Consequently, the local currency appreciates, prompting local agents to increase their stock of foreign currency loans – assuming they have favourable expectations about exchange rate stability. In such a case, monetary policy becomes less effective in dealing with local imbalances (due to a contraction of the credit channel), as there is a need of a larger response from the instrument in order to have a similar effect on domestic demand (compared to the case when all loans are expressed in local currency). The simulations

Fig. 5. Consumer welfare with respect to central bank responses to inflation and exchange rate (smoothed versus non-smoothed). Notes: The figure depicts consumer welfare with respect to the degree of exchange rate management (in terms of misalignment and growth rate) and the monetary policy response to inflation. The response to output gap is set at the estimated value (γ Y ¼ 0:26). The stochastic environment is composed of all non-policy related shocks in the model. Smoothing versus non-smoothing refers to the strategy used by the central bank with respect to how foreign exchange interventions are performed.

related to domestic variables, one key point being the monetary policy stance. When the central bank does not intervene in the foreign exchange market and the economy is affected by various shocks (in general supply or cost-push shocks), the successfulness of monetary policy depends on the exchange rate to adjust in order to restore the equilibrium. However, when the central bank resorts to interventions, the favourable economic context created by the exchange rate movement fades away. Consequently, the monetary policy tries harder to restore equilibrium in the local economy, but without much success – the volatility of local output (and consumption) is significantly higher. This tension is captured by the inverse relation between volatility of the exchange rate and nominal interest rates that emerges in such a situation (Fig. 6). To better illustrate this fact, let us come back to a shock that increases

Fig. 6. Interaction between money market and foreign exchange market. Notes: The figure depicts the trade-off between the volatility of the interest rate (percent, annualised) and the standard deviation of the real exchange rate (percent) when the central bank manages the exchange rate firmer, by varying the response to exchange rate misalignment and growth rate (γ Fq and γ FΔq take values between 0 and -10). The Taylor rule is parameterised based on estimated values for the feedback coefficients (γ R ¼ 0:84; γ π ¼ 2:65 and γ Y ¼ 0:26, respectively). The stochastic environment is composed of all non-policy related shocks. 14

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markets. In addition, a good knowledge of the domestic economic structure, along with robust evaluations of the competitiveness position of the economy, increases the central bank’s awareness of the net social costs incurred by exchange rate management, which is likely to augment the probability of success of such a monetary policy regime.

in this paper highlight the growing stabilisation costs in terms of individuals’ welfare faced by the central bank when the share of foreign currency loans in the loan stock widens. Altogether, the results of the paper suggest that central banks need to take into account agent heterogeneity and the source of exchange rate imbalance when they decide to intervene in the foreign exchange

A. Appendix In what follows, a comprehensive list of model equations is presented. As a general remark, the equation describing the exogenous processes (which have a first-order autoregressive representation, with white noise errors), that link actual data to the model variables and some trivial identities are left out (price and wage indexation rules). Nonetheless, the complete list of model equations, alongside mathematical derivations, is available upon request. The interested reader should note that lowercase variables denote real terms and the timing convention is that predetermined variables are introduced with a lag. A.1 Households The first order condition with respect to consumption: ΛH;t pC;t ¼ Et ½εC;t ðcH;t  hH cH;t1 ÞσH  hH βH εC;tþ1 ðcH;tþ1  hH cH;t ÞσH 

(A.1)

and with respect to savings: ΛH;t ¼ βH Rt Et

  ΛH;tþ1

(A.2)

π tþ1

ΛH;t is the budget constraint multiplier, pC;t the index of consumer prices, cH;t is the level of household consumption, Rt is the interest rate and π tþ1 is the inflation rate. εC;tþ1 is a consumption preference shock. βH is the discount factor and σ H is the risk aversion parameter. A.2 Labour unions The optimal wage is given by:

~ t ¼ An w

μW

AW;t μW  1 BW;t

1þμ 1

W σN

(A.3)

whereas the aggregated wage index is:



1μW 11μ W ΠW;t ~ t 1μW þ θW wt1 wt ¼ ð1  θW Þ w

(A.4)

πt

The auxiliary equations have the following form: σN AW;t ¼ εN;t n1þ wμt W t

ð1þσ N Þ



μW ð1þσ N Þ  ΠW;tþ1 þ Et βH θW AW;tþ1

(A.5)

π tþ1



1μW  ΠW;tþ1 BW;tþ1 BW;t ¼ ΛH;t nt wμt W þ Et βH θW

(A.6)

π tþ1

Price dispersion:

μW

μW ~t w wt1 ΠW;t þ θw ΔW;t1 ΔW;t ¼ ð1  θW Þ wt wt π t

(A.7)

W π 1ξW is the wage indexation rule, θW is the Calvo parameter, σ N the inverse Frisch elasticity and μ μW1 is the wage mark-up. εN;t is a where ΠW;t ¼ π C;t1

ξ

W

labour preference shock. A.3 DCL entrepreneurs The first-order conditions with respect to consumption cD;t , new loans denominated in local currency, lD;t , (combined with the first order condition with respect to the default threshold, ωD;t ), the stock of capital: pC;t ΛD;t ¼ εCE;t ðcD;t  hD cD;t1 Þσ D  βD hD εCE;tþ1 ðcD;tþ1  hD cD;t ÞσD

(A.8)

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 βD RLD;t ΛD;tþ1 π tþ1 ð1  μBD ωD;t HD;t Þ

 ΛD;t ¼ Et

pKD;t ¼

βD ΛD;tþ1 ΛD;t

(A.9)



rKD;tþ1 þ ð1  δK Þ pKD;tþ1 1  μBD Gt ðωD;t Þ  LTVD;t

μBD ωD;t HD;t 1  μBD ωD;t HD;t

 (A.10)

where cD;t is the consumption of DCL entrepreneurs, ΛD;t is the budget constraint multiplier, HD;t ¼ f ðωD;t Þ=1  Ft ðωD;t Þ is the hazard rate, rKD;t is the rental rate of capital and pKD;t is the price of capital acquired by DCL entrepreneurs. βD is the discount factor, hD is the habit formation parameter, μBD is the monitoring cost. Next, the endogenous Loan-to-Value ratio is given by the following equation: LTVD;t ¼ ωD;t ð1  Ft ðωD;t ÞÞ þ ð1  μBD ÞGt ðωD;t Þ

(A.11)

The participation constraint of commercial banks:

ηL lD;t RLD;t ¼ LTVD;t ð1  δK Þπ tþ1 pKD;tþ1 kD;t

(A.12)

lD;t is the amount of loans taken by DCL entrepreneurs and RLD;t is the related interest rate. The budget constraint: 1

ηL pC;t cD;t þ pKD;t kD;t þ ηL RLD;t1 lD;t1 þ pC;t ηL τt ¼ ηL lD;t þ ð1  μBD Gt ðωD;t ÞÞð1  δK ÞpKD;t kD;t1 þ rKD;t kD;t1 πt

(A.13)

A.4 FCL entrepreneurs The equations that describe their behaviour are presented in the main body of the paper (Section 2.1). A.5 Retailers In the model, nominal rigidities are introduced by specifying the specialised agents who operate in a monopoly environment and resort to Calvo-type framework when setting the prices. Therefore, the optimal price set by domestic retailers is: pt ¼ ~

μH;t AH;t μH;t  1 BH;t

(A.14)

The auxiliary equations:

AH;t ¼ ΛH;t mcD;t yH;t þ βH θH

BH;t ¼ ΛH;t yH;t þ βH θH

ΠH;tþ1

μH;t

π tþ1

1μH;t ΠH;tþ1

π tþ1

(A.15)

AH;tþ1

(A.16)

BH;tþ1

The aggregate price index: 1μH;t

1 ¼ ð1  θH Þ ~ pt

þ θH

ΠH;t

1μH;t (A.17)

πt

and price dispersion: μH;t

pt ΔH;t ¼ ð1  θH Þ ~

þ θH

μH;t ΠH;t

πt

ΔH;t1

(A.18)

mcD;t is the price paid by retailers which is the same with local producers’ marginal costs (since they operate in a competitive environment), μ

μH;t

H;t 1

is the

time varying mark-up of domestic retailers, ΠH;tþ1 the indexation rule. The optimal price set by exporters is: ~ pHX;t ¼

μHX;t AHX;t μHX;t  1 BHX;t

(A.19)

The auxiliary equations: AHX;t ¼ ΛH;t

μHX;t mcD;t ΠHX;tþ1 ðμHX;t Þ yHX;t pHX;t þ βH θHX AHX;tþ1  qt π tþ1

(A.20)

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1μHX;t ΠHX;tþ1 ðμHX;t Þ BHX;t ¼ ΛH;t yHX;t pHX;t þ βH θHX BHX;tþ1 : 

(A.21)

π tþ1

The aggregate price index:



 1μ 1μ1HX;t  ð1μHX;t Þ ΠHX;t ð HX;t Þ þ θHX pHX;t1  pHX;t ¼ ð1  θHX Þ ~ pHX;t

(A.22)

πt

and price dispersion: ΔHX;t ¼ ð1  θHX Þ



μHX;t

μHX;t pHX;t μHX;t ~ pHX;t1 ΠHX;t þ θHX ΔHX;t1 pHX;t pHX;t πt

where θHX is the Calvo parameter. μ

μHX;t

HX;t 1

(A.23)

is the mark-up of exporting retailers, ΠHX;t the indexation rule, yHX;t is the demand for exporting intermediate

π t

is the foreign inflation rate. goods and Now, turning to importing retailers, they are of two types, one that import goods with the purpose of being used for the production of export goods (indexed with IX) or for the final domestic good (indexed with M); I ¼ ½IX; M. The optimal price set by importers is: ~ pI;t ¼

μI;t AI;t μI;t  1 BI;t

(A.24)

The auxiliary equations:  μ AI;t ¼ ΛH;t qt yI;t pI;t I;t þ βH θI

μI;t ΠI;tþ1

π tþ1

(A.25)

AI;tþ1

1μI;t  μ ΠI;tþ1 BI;tþ1 BI;t ¼ ΛH;t yI;t pI;t I;t þ βH θI

(A.26)

π tþ1

The aggregate price index:



1μI;t 11μ  ð1μI;t Þ I;t ΠI;t þ θI pI;t pI;t1 pI;t ¼ ð1  θI Þ ~

(A.27)

πt

and price dispersion:

μI;t

μI;t μI;t ~ pI;t pI;t1 ΠI;t þ θI ΔI;t1 ΔI;t ¼ ð1  θI Þ pI;t pI;t πt

(A.28)

where θ’s are the Calvo parameters, μ’s are the elasticity of substitution among different goods varieties and y’s denote the demand for a particular type of goods. A.6 Intermediate goods producers The production function has a standard Cobb-Douglas form: α yt ¼ εY;t k αt1 n1 t

(A.29)

Profit maximisation results in the following definition for the marginal costs: mcD;t ¼

α rαK;t w1 t

(A.30)

εYt ð1  αÞ1α αα

and the following factor shares: rK;t α nt ¼ wt 1  α kt1

(A.31)

A.7 Capital producers Capital accumulation for DCL entrepreneurs: kD;t ¼ ð1  δK ÞkD;t1 þ ΦKD;t ηL iD;t

(A.32) 17

M. Viziniuc

Economic Modelling xxx (xxxx) xxx

The adjustment costs: ΦKD;t ¼ 1 

2 κK iD;t 1 2 iD;t1

(A.33)

Price of capital:

pC;t ¼ pKD;t

 2  

2 iD;t κK iD;t ΛH;tþ1 iD;tþ1 iD;tþ1 1  1 1 þ κ K pKD;tþ1 βH iD;t1 iD;t1 2 iD;t1 ΛH;t iD;t iD;t

1  κK

iD;t

(A.34)

The setup of producers who sell capital to FCL entrepreneurs is similar. A.8 Aggregators Demand for capital of DCL entrepreneurs: kD;t ¼ ηL

φK rKD;t kt rK;t

(A.35)

and of FCL entrepreneurs:

φK rKF;t kt kF;t ¼ ð1  ηL Þ rK;t

(A.36)

The rental rate of capital is given by:

1 ð1φ Þ ð1φ Þ 1φK rK;t ¼ ð1  ηL Þ rKF;t K þ ηL r KD;t K

(A.37)

In the case of export goods, the demand for domestically-produced ones is given by: yHX;t ¼ ηX

φX pHX;t yX;t pX;t

(A.38)

And for imported goods:

φX pIX;t yIX;t ¼ ð1  ηX Þ yX;t qt pX;t

(A.39)

The export goods price index is: 1φX  1



 1φX 1φX pIX;t þ ηX pHX;t pX;t ¼ ð1  ηX Þ qt

(A.40)

As for the final domestic consumption good, the demand for domestically-produced ones is given by:

φG 1 yH;t ¼ ð1  ηG Þ yAB;t pC;t

(A.41)

And for imports:

yM;t ¼ ηG

pM;t pC;t

φG (A.42)

yAB;t

where yAB;t is the absorption of the economy. The consumer price index is given by:   1φG 1φ1 G pC;t ¼ 1  ηG þ ηG pM;t

(A.43)

A.9 Retail banks The interest rate on domestic currency loans: 1  μLD;t þ

 



2 Rt μLD;t RLD;t RLD;t ΛH;tþ1 RLD;tþ1 RLD;tþ1 lD;tþ1 ¼ κ LD  1 þ βH κ LD 1 RLD;t RLD;t1 RLD;t1 ΛH;t RLD;t RLD;t lD;t

and on foreign currency loans:

18

(A.44)

M. Viziniuc

1  μLF;t þ

Economic Modelling xxx (xxxx) xxx

φRP;t Rt stþ1 μLF;t ¼ κ LF RLF;t

 

2 RLF;t RLF;t ΛH;tþ1 RLF;tþ1 RLF;tþ1 lF;tþ1 1 þ βH κLF 1 RLF;t1 RLF;t1 ΛH;t RLF;t RLF;t lF;t



(A.45)

A.10 Wholesale banks The equation describing their behaviour is available in the main body of the paper (Section 2.2). A.11 Market clearing conditions Loan aggregation lE;t ¼ ηL lD;t þ ð1  ηL Þqt lF;t

(A.46)

Aggregate investment: iK;t ¼ ηL ΦKD;t iKD;t þ ð1  ηL Þ ΦKF;t iKF;t

(A.47)

Absorption of the economy: 1 qt yAB;t ¼ pK;t iK;t þ pC;t cH;t þ pC;t ðηL cD;t þ ð1  ηL ÞcF;t Þ þ pC;t gt þ ΦLD;t1 þ  ΦLF;t1

πt

πt

(A.48)

Domestic production: yt ¼ yH;t ΔH;t þ yHX;t ΔHX;t

(A.49)

Nominal gross domestic product: pY;t yt ¼ yAB;t þ qt pX;t yX;t  pM;t yM;t  pIX;t yIX;t

(A.50)

Appendix A. Supplementary data Supplementary data to this article can be found online at https://doi.org/10.1016/j.econmod.2020.02.016.

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