Summary:
In recent years, the elasticity and volatility of the RMB exchange rate have been rising. Although it contributes to the improvement of pricing efficiency and openness for the foreign exchange market, it also introduces broader foreign exchange risks. According to statistics from the Bank for International Settlements, at the end of the third quarter of 2024, China's debt position to cross-border banks reached $\$$962.8 billion. The total amount of foreign currency debt was 401.5 billion US dollars, accounting for about 40% of the total foreign debt, and half of these foreign currency debts were from the banking sector. Financing of Chinese enterprises relies primarily on the banking system, and the banking sector not only plays a key financial intermediation role, but also provides funds to the real economy. Exchange rate risks brought by foreign currency exposure of banks warrant the attention of policy makers.According to the “currency mismatch” theory, depreciation of the domestic currency could cause pressure on banks holding foreign currency liabilities to repay them. In the case where foreign currency assets are difficult to fully hedge, the net worth of banks will shrink. Consequently, their lending capacity declines, and credit supply reduces. It is called the “bank lending channel” of exchange rate transmission. The bank lending channel of the exchange rate has been confirmed in several developed countries. China is stepping in a new stage of promoting the two-way opening of its financial market, with foreign currency liabilities accumulating. However, the foreign exchange derivatives market that manages exchange rate risks remains in development, making it easier to observe changes in bank's net worth caused by foreign currency exposure. Besides, compared to developed countries, bank credit is the main source of financing for Chinese enterprises. Thus, the changes in real investment caused by credit contraction further amplify the impact of foreign exchange risks on banks.Using data from Chinese commercial banks, loans, and enterprises from 2010 to 2019, we examine the currency depreciation following China's 2015 exchange rate policy adjustment to verify the bank lending channel of exchange rate. Our findings indicate that the currency depreciation shock causes a decline in the supply of credit by banks with higher foreign currency exposure, due to the effects of both liability side and asset side after decomposing the net exposure. The supply effect remains robust even after controlling firm's credit demand using loan-level data. Moreover, we show that firms that rely heavily on banks with higher foreign currency debt ratio experience a decline in real investment; that is, the exchange rate fluctuations can transmit to the real economy through bank's foreign currency exposure.The contributions of this paper are as follows. First, our research establishes a detailed dataset of Chinese commercial banks' foreign currency assets and liabilities, which provides more evidence on how foreign currency exposure of the banking system works on emerging markets. Second, while existing literature has explored the relationship between currency crises and banking crises, and found they are often “twin crises”, there are few studies on the relationship between exchange rate depreciation and bank credit during non-crisis periods. This research confirms that exchange rate depreciation could make banks reduce credit supply in normal times. Third, the paper explores the relationship between exchange rate and investment from the perspective of bank credit and explores bank behavior in detail, which is a novel perspective to existing studies.The paper has important policy implications on exchange rate risk management. On the one hand, the banking sector should strengthen the matching of foreign currency assets and liabilities, including the currency type, maturity and interest rate of foreign exchange positions, to avoid repayment risks caused by the imbalance of them. On the other hand, enterprises should consider exchange rate risks from broader sources, that is, not only the direct exchange rate risk from their own foreign currency debts, but also indirect risks from highly exposed banks which provide loans to them.
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