Banking Limits on Foreign Holdings

Banking Limits on Foreign Holdings

Disentangling the Portfolio Balance Channel

Pamela Cardozo Fredy Gamboa David Perez Mauricio Villamizar

Central Bank of Colombia

Introduction

Intervention can affect exchange rate through two channels

Signaling channel

Portfolio balance channel

In this paper we aim to disentangle the portfolio balance channel

Limits on exposure

In Colombia banks have limits on their dollar exposure

Banks are key players in COP-USD market

When limits on exposure bind, banks are no longer indifferent between assets in pesos and dollars

In this paper

Construct a tractable model

Agents have limits on foreign exchange positions

When binding, this friction causes a departure from UIP: portfolio balance channel

What we find

Multiple equilibria

Constraints are not binding

UIP holds: agents are indifferent between foreign and domestic assets

Exchange rate is constant

Constraints bind

UIP does not hold: wedge on expected returns depends on relative amount of foreign bonds

What we find

Foreign exchange intervention helps to overcome wedge caused by departure from UIP

Welfare is constant in both equilibria:

Households cannot consume more than exogenous endowment

Friction only affects foreign assets

Mechanism

Relation between returns of assets depends on friction

If UIP does not hold

Agents want to save in asset with higher return

Limits in exposure bind

Empirical methodology

Test postulations of model with RDD

Use regulation limits for Colombian banks on their net short-term assets in US dollars

When limits are binding:

Effects of intervention by Central Bank on exchange rate are significant, but short-lived

Literature review

Theoretical underpinnings of channels through which exchange rate can be affected: Sarno and Taylor (2001), Evans (2005), Lyons (2006), Villamizar-Villegas and Perez-Reyna (2015)

No empirical consensus on effectiveness of foreign exchange intervention: Dornbusch (1980), Meese and Rogoff (1988),

Dominguez and Frankel (1993), Edison (1993), Dominguez (2003), Fatum and Hutchison (2003), Neely (2005), and Menkhoff (2010)

Model

Two periods

Small open economy: exogenousr∗

Representative household:

Exogenous endowment,At

u(c) = lnc

Choose whether to save in domestic or foreign assets

Government

Issues domestic debt

Government

Exogenous

t = 0:

Issues debt in pesos: BG

Acquires assets in dollars: e0BG∗

t = 1:

Pays back debt in pesos: (1 +r)BG

Government

Budget is balanced through lump-sum transfers:

τ0≡BG −e0BG∗

τ1≡(1 +r∗)e1BG∗ −(1 +r)BG

Real economy:

Household

Present value of income

I ≡A0+τ0+

A1+τ1

1 +r

Limits on exposure to dollars:

B≤ e0B

∗

Household

max

c0,c1,B,B∗

lnc0+βlnc1

s. t. c0+B+e0B∗=A0+τ0

c1= (1 +r)B+ (1 +r∗)e1B∗+A1+τ1

B ≤e0B

∗

Market clearing

Domestic bond market

B=BG

Exchange rate (we assumeCA= 0)

B∗+B_G∗ = 0 (1 +r∗) (B∗+B_G∗) = 0

We are able to pin down r and e1

e0

Competitive equilibrium

A competitive equilibrium in this economy is pricesP={e1,r}

allocationsX ={c0,c1,B,B∗}

government policies G ={BG,BG∗}

such that

1 given P, X is a solution to the problem of the household

Characterizing equilibria

Welfare is constant: consumption cannot exceed endowment

ct =At

Friction is on foreign assets

1 +r =TMS= A1 βA0

Relation between

r

and

r

In equilibrium

1 +r =e1(1 +r∗)−

λ−λ β c1

λ: Lagrange multiplier of upper bound on dollar exposure

Multiplicity of equilibrium

1 +r =e1(1 +r∗)

⇐⇒ household is indifferent between domestic and foreign assets

⇐⇒ λ=λ= 0

1 +r <e1(1 +r∗)

⇐⇒ household prefers to save in dollars

⇐⇒ λ >0 andλ= 0

1 +r >e1(1 +r∗)

Proposition

AssumeB<0<B. Let

B∗_G ≡ −B(1 +β)A0

B∗_G ≡ −B(1 +β)A0

Two equilibria: B_G∗ ∈B∗_G,B∗_G

1 _{Constraints don’t bind}

2 _{Constraints bind}

B_G∗∈ B∗_G,0

: upper constraint binds

B∗

G∈

0,B∗G

Proposition

When constraints don’t bind

e1=

1 +r

1 +r∗ =

A1

βA0

1 1 +r∗

Proposition

If constraints bind: e. g. B_I∗ =B

e1=

1 +r

1 +r∗



   

1−1 B −

(1 +β)A0

B∗

G

| {z }

Wedge     

Intervention affectse1

Increasing|BG∗|helps to decrease wedge ine1

Intervention drivese1 towards value achieved in equilibrium without

e

for different values of

B

Intuition

Departure from UIP

ρ≡1 +r−e1(1 +r∗)

Ifρ= 0, we are in the no-binding equilibrium

No distortion, no wedge ine1,e1constant

Intuition

Consider equilibrium with constraints that bind

AssumeB_G∗ >0

From market clearing,B∗<0

Lower constraint binds

Intuition

AssumeB_G∗ increases

B∗must decrease

ρmust increase to makeB∗less valuable to household (relative to

B)

ρ= 1 +r−e1(1 +r∗)

Mechanically

Income of household:

I =A0+

A1

1 +r −

ρB∗

G

1 +r

B is fixed. IfB∗ decreases thenI must increase

B= B

∗

I

ρ

for different values of

B

-2 -1 0 1 2

Empirical methodology

We test postulations of model

Estimate casual effect of banking limits on exchange rate: RDD

Idea:

Banks with foreign exposure close to limit are similar to banks on limit

Limits on

PPC

PPC: posici´on propia de contado

Net short-term assets in US dollars

Exposure of Colombian banks to US dollars is limited by regulation

max: 50% of the equity of a bank, since 1999

Cutoff we care about: 1%

Data is far from upper limit

Penalty if bounds are reached

PPC does not depend solely on decision of banks

e.g. exchange rate affectsPPC

It is reasonable to have a buffer

Empirical exercise

Observable variable: PPC to equity, Xt

Cutoff value: 1%,x0

Assignment of treatment:

Dt≡1{Xt≥x0}

Specification:

∆et =β0+β1Dt+ϕ0(Xt−1−x0) +ϕ1(Xt−1−x0)×Dt+t

Foreign exchange intervention

Central Bank intervention in the period: 52% of observations

IRF’s

We follow Jorda (2005):

Method of local projections to estimate the implied IRF’s

Empirical exercise:

Estimate effect on ∆et separately for periods where there was

intervention and where there wasn’t

We find that effects of foreign exchange intervention when PPC is at the limit are

Positive and significant

Portfolio shifts

We consider effects of banking limits on portfolio balances

etL∗t

Lt : Loans in dollars to loans in pesos

We find that banks shift assets when they reach limit on dollar exposure

Sheds light on portfolio channel:

Conclusion

We analyze the portfolio balance channel by studying the effects of banking limits established by financial regulations.

We make two contributions:

We construct a tractable model: foreign exchange intervention has an effect one when limits bind.