Cross-border Borrowing of Financial Institutions, Exchange Rate Regime and Macroprudential Policy
Wen Xingchun, Mei Dongzhou, Gong Liutang
China School of Banking and Finance, University of International Business and Economics; School of International Trade and Economics, Central University of Finance and Economics; Institute for Advanced Study, Wuhan University
Summary:
China is expanding the external openness of its financial sector while concurrently advancing the processes of Renminbi (RMB) internationalization through market-oriented reforms in RMB exchange rate and the reduction of capital controls. Consequently, understanding how cross-border borrowing of financial institutions impacts a country's economic fluctuations and determining measures to mitigate associated risks are crucial theoretical and practical considerations. This is particularly pertinent in the current highly complex and uncertain international environment. The urgent need is to investigate the mechanisms through which cross-border borrowing of financial institutions affects the economy and to conduct in-depth analysis on the coordination between cross-border borrowing of financial institutions and exchange rate marketization and policies such as cross-border financing regulation. To address this, we introduce cross-border borrowing of financial institutions into a Dynamic Stochastic General Equilibrium (DSGE) model, analyzing the relationships among cross-border borrowing of financial institutions, exchange rate regime selection, and cross-border financing regulatory policy. Numerical simulation results indicate that, when financial institutions engage in cross-border borrowing, external shocks impact capital inflows and outflows, causing exchange rate fluctuations. This then affects the financial intermediary's balance sheet, leading to a reduction in the financial intermediary's lending to the real sectors and ultimately resulting in adverse effects on investment and output. If not taking cross-border financing regulatory policy into account, when cross-border borrowing or the cross-border borrowing by financial institutions doesn't exist or is low, the floating exchange rate regime outperforms the fixed exchange rate regime in terms of output stability and welfare implication, aligning with traditional conclusions of studies on monetary policy in open economies. However, with the increase in the scale of foreign debt borrowed by financial institutions, the negative impact of capital flows and exchange rate fluctuations on the financial system increases. At this juncture, relative to a floating exchange rate, a fixed exchange rate regime proves effective in stabilizing the exchange rate, reducing the volatility of capital flows, and consequently mitigating output fluctuations and welfare losses. Furthermore, the study assesses the role of macroprudential regulatory policy in cross-border borrowing of financial institutions and RMB exchange rate marketization. Results indicate that cross-border financing regulatory policy can mitigate capital flow and exchange rate volatility under cross-border borrowing of financial institutions, thereby reduces the adverse impact of external shocks on the financial intermediary's balance sheet, leading to decreased output fluctuations and welfare losses. The efficacy of regulatory policy increases as the scale of cross-border borrowing by financial institutions increases. In the presence of cross-border financing regulatory policy, the output fluctuations and welfare losses under a floating exchange rate regime are lower than those under a fixed exchange rate regime. Based on these conclusions, the paper proposes the following policy recommendations. Firstly, as the opening up of financial institutions progresses, China should vigilantly guard against adverse international economic impacts, such as rising global interest rates. The frequent movement of cross-border capital can amplify financial intermediary volatility and systematic financial risks, exacerbating macroeconomic fluctuations. Establishing and refining a policy framework to address cross-border financing risks in the financial intermediary, including implementing macroprudential controls for cross-border financing, is crucial. Secondly, while acknowledging the inevitability of financial institutions' openness, it is imperative to expedite the establishment and improvement of a regulatory framework for cross-border capital flows. On this foundation, the gradual promotion of RMB exchange rate marketization is recommended, allowing for increased exchange rate flexibility. Without a well-coordinated cross-border financing regulation framework, hastening the cross-border borrowing of financial institutions and endorsing exchange rate marketization could compromise the overall financial system's stability, triggering systemic financial risks and potentially inciting a financial crisis, thereby intensifying economic fluctuations. Thirdly, until a comprehensive cross-border financing regulatory framework is in place to manage capital flows, maintaining exchange rate stability and restricting cross-border capital movements remains a necessary means to mitigate adverse impacts of external shocks and guard against systemic financial risks. In comparison to existing literature, the contributions of this paper lie in several aspects. Firstly, departing from prior studies that predominantly focused on currency mismatches in the balance sheets of enterprises in an open economy, this paper focuses on the balance sheets of financial intermediaries to investigate the impact of cross-border borrowing of financial institutions on economic fluctuations. This is particularly relevant given the accelerating opening up of China's financial industry and provides a foundational analytical framework for subsequent research. Secondly, the findings of this paper provide a novel perspective on understanding the impact of cross-border borrowing of financial institutions on macroeconomic policies. Cross-border borrowing of financial institutions amplifies economic volatility resulting from external shocks. Without considering cross-border financing regulatory policy, a fixed exchange rate regime outperforms a floating exchange rate regime in terms of both output fluctuations and welfare implication, which is significantly different from the previous results derived from the perspective of enterprise behavior. Finally, beginning with the stability of the financial system, this paper comprehensively synthesizes the coordination and collaboration among cross-border borrowing of financial institutions, floating exchange rates, and cross-border financing regulatory policy within a general equilibrium framework. This holds theoretical significance and provides policy insights for the ongoing practice of financial institutions' openness.
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