A Risk-based Theory of Exchange Rate Stabilization

Abstract

We propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country's currency to appreciate in bad times lower its risk premium in international markets and, as a result, lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country ("currency stabilization"), we find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country. Differences in real interest rates across developed economies are large and persistent; some countries have lower real interest rates than others for decades rather than years. These longlasting differences in interest rates correlate with differences in capital-output ratios across countries, and account for the majority of excess returns on the carry trade, a trading strategy where international investors borrow in low interest rate currencies, such as the Japanese yen, and lend in high interest rate currencies, such as the New Zealand dollar ( Lustig, Roussanov, and Verdelhan, 2011; Hassan and Mano, 2015; Hassan, Mertens, and Zhang, 2015).A growing literature studying these "unconditional" differences in currency returns argues that they may be attributable to heterogeneity in the stochastic properties of exchange rates:Currencies with low interest rates pay lower returns because they tend to appreciate in bad times and depreciate in good times, providing a hedge to international investors and making them a safer investment (Lustig and Verdelhan, 2007;Menkhoff et al., 2013). This literature has explored various potential drivers of heterogeneity of the stochastic properties of countries' exchange rates, ranging from differences in country size (Martin, 2012;Hassan, 2013) and financial development (Maggiori, 2013) to trade centrality (Richmond, 2015) and differential resilience to disaster risk (Farhi and Gabaix, 2015). 1 The common theme across these papers is that whatever makes countries different from each other results in differential sensitivities of their exchange rates to various shocks, such that some currencies tend to appreciate systematically in "bad" states of the world (when the price of traded goods is high). Currencies with this property then pay lower expected returns a...

Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

“…We show that these risk premia have real effects on government fiscal policy. Similarly to Hassan (2013) and Hassan, Mertens, and Zhang (2016), we argue that government bond yields reflect the insurance value for lenders, even though the source of comovement that we focus on—monetary policy credibility—is different.…”

Forward and Spot Exchange Rates in a Multi-currency World

“…6 Also see Caballero et al (2008), Govillot et al (2010), Berg and Mark (2015), Farhi and Gabaix (2016), Hassan et al (2016), Zhang (2018), and Wiriadinata (2018).…”

Not so disconnected: Exchange rates and the capital stock

“…13 Beyond more quantitative applications, a link between the stochastic properties of exchange rates and factor allocation across countries also poses interesting normative questions because it may create incentives to manipulate these stochastic properties. In Hassan, Mertens, and Zhang (2015), we take a step in this direction by studying the effect of currency pegs on capital accumulation across countries. Verdelhan, A.…”