A  paper by Bruno and Shin illustrates how global banks drive lending booms in local currency markets. Most importantly, they explain how currency strength fuels rather than curbs financial expansion in small and emerging economies, leading to escalating dynamics. Conversely, dollar strength can trigger a tightening spiral. Empirical evidence seems to support the point.

Bruno, Valentia, and Hyun Song Shin, “Cross-border Banking and Global Liquidity”, BIS Working Papers, No 458, August 2014.
http://www.bis.org/publ/work458.pdf

The below are excerpts from the paper. Emphasis and cursive text have been added.

A theory of global banking, exchange rates, and local credit supply

“[We] construct a model of global liquidity built around the operation of international banks. We build on recent advances in understanding the leverage cycle of banks in which leverage builds up in booms and falls in busts. The leverage cycle mirrors the fluctuations in collateral requirements (increased haircuts) during downturns… In particular, we construct a double-decker model of banking where regional banks borrow in US dollars from global banks in order to lend to local corporate borrowers. In turn, the global banks finance cross-border lending to regional banks by tapping US dollar money market funds in financial centres.”

“Although the banks are hedged in their currency exposure, the ultimate local borrower has a currency mismatch, financing local currency assets with US dollar borrowing. The motive for the currency mismatch could be to hedge US dollar receivables when costs are in local currency, or the mismatch may be due to speculative motives.”

“[There is a] link between local currency appreciation and loosening of financial conditions through the build-up of leverage in the banking sector. The channel is through shifts in the effective credit risk faced by banks who lend to local borrowers that may have a currency mismatch [local-currency revenues and USD liabilities]. When the local currency appreciates, local borrowers’ balance sheets become stronger, resulting in lower credit risk and hence expanded bank lending capacity. In this way, currency appreciation leads to greater risk-taking by banks… our results shed light on why dollar appreciation constitutes a tightening of global financial conditions, and why financial crises are associated with dollar shortages.”

“The combination of the rapid growth of the banking sector fuelled by capital inflows and an appreciating local currency has been a classic early warning indicator of emerging economy crises. Gourinchas and Obstfeld (2012) conduct an empirical study using data from 1973 to 2010 and find that two factors emerge consistently as the most robust and significant predictors of financial crises, namely a rapid increase in leverage and a sharp real appreciation of the currency.”

Empirical evidence

“Our sample for the panel investigation draws on data from 46 countries, encompassing both developed economies and emerging/developing economies [apparently mostly from 1999 to 2011].”

“Capital flows through the international banking system have been a substantial proportion of total cross-border debt flows… [The figure below] shows the classification of cross-border debt liabilities by type of counterparty. We see that cross-border liabilities where both the creditor and debtor are banks is the largest of the four possible categories, and saw rapid increases in the run-up to the 2008 crisis.”

Bank-to-bank flows have also played a major role in the expansion of domestic lending. The left hand panel shows cross-border bank-to-bank liabilities as a proportion of GDP, while the right hand panel shows cross-border bank-to-bank liabilities as a proportion of private credit. At the peak in 2007, bank-to-bank cross-border liabilities accounted for 20% of total private credit and for over 30% of GDP.”

“One prediction of our model is that episodes of appreciation of the US dollar are associated with deleveraging of global banks…In our panel study of 46 countries we find that an appreciation of the local currency vis-à-vis the US dollar is associated with an acceleration of bank capital flows in the subsequent quarter.

“An implication of [our theoretical proposition]…is that both the level of bank leverage and the change in the leverage [of banks] should enter as supply push determinants of banking flows. We find strong support for these predictions in our panel study, thereby verifying that the factors driving bank flows can be found in the determinants of bank leverage.”