Trade-weighted exchange rates help assessing the impact of past currency depreciation on economic growth through the external trade channel. Debt-weighted exchange rates help assessing the impact of past currency depreciation on economic growth through the financial channel. Since these effects are usually opposite looking at both simultaneously is crucial for using exchange rate changes as a predictor of economic and local market performance. For example, as a consequence of the financial channel many EM economies fail to benefit from currency depreciation in the way that small developed economies do.

Kerns, Jonathan and Nikhil Patel (2016), “Does the financial channel of exchange rates offset the trade channel?”, BIS Quarterly Review, December 2016.

Berger, Bat-el (2016), “Debt weighted exchange rate indices”, 11 December 2016.

The post ties in with the subject of information efficiency and this site’s lecture on fundamental value estimates, particularly in the foreign exchange space.

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

The two channels of exchange rate impact

“The trade channel [refers to] the effect of the exchange rate on economic activity…Appreciation raises the international cost of exports, reducing both export demand and the domestic cost of imports, leading to substitution away from domestic production. Thus, appreciation is contractionary for domestic economic activity, while depreciation is expansionary.”

“Depreciation can stimulate economic activity through exports even if there is no pass-through to foreign currency export prices. If foreign currency export prices are unchanged with a depreciation, then the domestic currency price of exports will rise. The increased profits resulting from higher prices can stimulate investment through greater retained earnings, or consumption…Overall, the strength of the trade channel for an economy will depend not only on the responsiveness of traded goods prices and volumes to the exchange rate but also on the share of exports and imports in economic activity…The strength of this channel is typically found to differ markedly across countries.”

“The financial channel of exchange rates, sometimes also referred to as the risk-taking channel, works in the opposite direction to the trade channel. The financial channel describes how exchange rate movements influence the supply and cost of foreign funding…The risk-taking channel is present whenever borrowers’ balance sheets are sensitive to exchange rate changes. This sensitivity can result from an imbalance in the currency denomination of a firm’s assets and liabilities or in the relationship of net cash flows to the exchange rate…We expect the effects of exchange rate changes through foreign currency liabilities to predominate over those through foreign currency assets. Foreign currency assets are often held by long-term investors, such as pension funds, or foreign exchange reserves managers.”

“Appreciation against global funding currencies increases the supply, and reduces the cost, of foreign lending. This will boost interest-sensitive domestic spending…The improved creditworthiness of borrowers that comes with a local currency appreciation can lift the supply of foreign currency lending…Indeed, BIS [research] shows that a 1% depreciation of the dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of dollar-denominated cross-border lending. In addition, if an appreciation results in an apparently lower risk profile for foreign currency borrowers, this may reduce their risk spreads and hence their borrowing costs.”

“In much the same way as an interest rate cut can stimulate the economy by transferring income from savers to borrowers, an appreciation can stimulate the economy through the transfer of net wealth from foreign currency savers to borrowers.”

View post on the self-reinforcing dynamics of EM currency trends, because of the risk-taking channel.

Whether…appreciation is contractionary or expansionary rests on whether the trade or financial channel predominates. The strength of the trade channel depends on the nature of trade flows, while the intensity of the financial channel depends on the sensitivity of domestic balance sheets to the exchange rate and the amount of foreign borrowing. The intensity of both of these channels can differ across countries…Appreciation may be contractionary for some countries but expansionary for others.”

How to calculate a debt-weighted exchange rate

“The relevant exchange rate for… the trade channel is sensitive to the trade-weighted exchange rate, i.e. the weighted exchange rate against countries with which the country trades and competes in global markets…The nominal effective exchange rate (NEER, which is trade-weighted) should capture the trade channel.
The relevant exchange rate for the financial channel is the one against international funding currencies, predominantly the US dollar and increasingly the euro, but also the yen, Swiss franc and pound sterling… the BIS-constructed debt-weighted exchange rate (DWER) proxies for the financial channel.”

“We…construct…benchmark DWER indices using the weights based on foreign currency-denominated total debt…We select that particular measure because it strikes…[a] balance between conceptual comprehensiveness and computability. Furthermore, it is the most direct counterpart to the trade-weighted exchange rate indices…That is, it captures the distribution of the foreign currency components of total debt (regardless of how large foreign currency debt is relative to debt in all currencies) in the same way that trade-weighted exchange rate indices capture the distribution of the foreign trade component of GDP (regardless of how large foreign trade is relative to GDP).”

“In more concrete terms, the DWER that we construct for each country is the geometric average of its bilateral exchange rates against each of the five major global funding currencies (US dollar, euro, Japanese yen, pound sterling and Swiss franc), weighted by the shares of these global funding currencies in that country’s foreign currency debt… The weight of a currency… is calculated using… cross-border loans to non-banks denominated in foreign currencies,… international debt securities statistics denominated in foreign currencies, issued by non-banks…[and] local loans to non-banks denominated in foreign currencies…Weights are calculated on a quarterly basis. For all days in a quarter, the end-of-quarter weights of the preceding quarter are applied.”

“The 61 countries for which debt-weighted exchange rate indices were calculated can be roughly split into four groups…[1] countries for which the DWER closely follows the bilateral US dollar exchange rate. This is, for example, the case for most Latin American countries…[2] countries for which the DWER and the trade-weighted NEER index are very similar. This is the case for several emerging European countries…[3] countries for which the DWER falls between the bilateral US dollar exchange rate and the trade-weighted index. This is the case for more than half of the countries in the sample…[4] Countries for which the DWER, the bilateral US dollar exchange rate and the trade-weighted NEER index are virtually the same…This involves countries that trade heavily with the United States, as Canada illustrates.”

Evidence for the relevance of debt-weighted exchange rates

“We use a univariate autoregressive distributed lag (ARDL) model to compute the short- and long-run elasticity of GDP and its components with respect to the two exchange rate variables….We analyse results from time series regressions that are run separately on each country and report medians across different country groups [in the table below].”

“We find evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for advanced economies. Investment is found to be particularly sensitive to the financial channel.”

“The positive elasticity for the DWER indicates that an appreciation tends to raise growth, while the negative elasticity for the NEER indicates that an appreciation tends to reduce growth. For the median EME, a 1% appreciation of the debt-weighted exchange rate leads to an increase in quarterly GDP growth of 0.1% in both the short and long run.10 Indeed, for 13 out of 22 EMEs, the sum of the DWER and NEER elasticities is positive, indicating that an equal appreciation of both measures would be expansionary.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.