An Evaluation of the Contractionary Devaluation Hypothesis

Abstract

*Recent empirical and theoretical literature on the impact of real exchange rate devaluations on economic performance questions the traditional expansionary effect generated within standard Mundell-Fleming models. Contractionary devaluations may arise when firms face maturity or currency mismatches that, when faced with real exchange rate depreciations, lead to balance-sheet effects that erode firms' wealth and lead to an output contraction. While some authors show that the standard Mundell-Fleming result may hold even in the presence of currency mismatches, others point out that, if the balance sheet effect is large enough, devaluations can be contractionary. Using a large panel of 57 countries across the world and various newly constructed measures of dollarization, we test whether the balance sheet effect hypothesis has been relevant during the past decades in explaining economic downturns. Additionally, we explore the channels through which devaluations can be contractionary; in particular, we explore whether investment and consumption decisions are negatively affected by exchange rate devaluations under currency mismatches.

Chronicle of Large Currency Devaluations: Re-Examining the Effects on Output

“…Cavallo, et al (2002) find that devaluations in the presence of large foreign currency liabilities can increase the value of debt relative to revenues, crippling insufficiently hedged debtors and leading to business failures and output contractions. Bebczuk et al (2007) find that devaluations are contractionary once dollarisation is controlled for. However, Cespedes (2005) finds contractionary balance sheet effects from real exchange rate devaluations only in the short-run; they have expansionary effects in the medium term.…”

The Impact of Anticipated and Unanticipated Exchange Rate Variability in Ukraine

“…At the same time, a decline in production is seen, both in the case of a devaluation under a fixed exchange rate and depreciation under a floating exchange rate (Ahmed et al, 2002). Restrictive devaluation is found to prevail in Latin American countries (Bebczuk et al, 2006;Pineres and Cantavella-Jorda, 2010), but it is also not uncommon in Asian countries either (Chou and Chao 2001;Moreno, 1999). Since an improvement in the trade balance is combined with a decline in the government revenues in Latin American countries , the aggregate supply is concluded to be the dominant factor.…”

“…In addition to the above mentioned context of the crisis or "normal" conditions, the varied impact of the exchange rate can also be attributed to heterogeneous factors such as the business cycle, the specifics of capital flows, economic dollarization, openness to foreign trade, critical overstatement of the RER, and related external conditions (Bebczuk et al, 2006;Bussière et al, 2012). The mechanisms of a restrictive exchange rate impact are no less diverse: low price elasticity of exports and imports, wage cuts, capital flight (Kamin and Rogers, 2000;Lizondo and Montiel, 1988), redistribution of income in favor of richer strata of the population with a higher propensity for saving, improvements in the budget balance because of higher tax revenues from exporter companies (Krugman and Taylor, 1978), a decrease in the value of financial assets of local companies (Delli Gatti et al, 2007), the balance effect when the post-devaluation costs of external debt servicing increase significantly (Blanchard et al, 2010).…”

Foreign Currency Loans and Credit Risk: Evidence from U.S. Banks

“…However, because of the balance sheet channel, devaluations can be contractionary (Bebczuk et al (2010) and Kohn et al (2015)), cause or worsen currency crises (Aghion et al (2001), Aghion et al (2004), Ranciere et al (2010a)), and create systemic risk (Dell'Ariccia et al (2016b) and Yesin (2013)). In addition, they may feed back onto bank balance sheets through higher credit risk, causing a reduction in cross-border lending (Bruno and Shin (2014) and Avdjiev et al (2016)).…”

“…Céspedes (2005) shows that devaluations have stronger negative effects on output for countries that are more indebted. Bebczuk et al (2010) analyze the role of dollar denominated debt for the effect of real depreciations on GDP growth, documenting that dollar debt can make devaluations contractionary. 5 Studies using micro-level data have analyzed the effect of foreign currency debt on firm investment and employment with mixed evidence on the balance sheet channel, as mentioned before.…”