Exchange rate effects of financial regulations

•Effects of banking constraints on exchange rate are short-lived.•These effects are only significant when financial regulation binds.•Effects are magnified during foreign exchange interventions.•This is consistent with regulation causing a departure from UIP. In this paper we analyze the effects of...

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Bibliographic Details
Published inJournal of international money and finance Vol. 96; pp. 228 - 245
Main Authors Perez-Reyna, David, Villamizar-Villegas, Mauricio
Format Journal Article
LanguageEnglish
Published Elsevier Ltd 01.09.2019
Subjects
Financial constraints
Policy discontinuity
Portfolio channel
Sterilized FX intervention
C31
Policy discontinuity
C21
F31
Portfolio channel
C14
Sterilized FX intervention
E58
Financial constraints
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Summary:•Effects of banking constraints on exchange rate are short-lived.•These effects are only significant when financial regulation binds.•Effects are magnified during foreign exchange interventions.•This is consistent with regulation causing a departure from UIP. In this paper we analyze the effects of financial constraints on the exchange rate through the portfolio balance channel. We use a sharp policy discontinuity within the Colombian financial system to empirically test for the portfolio balance channel, using high frequency data during the period of 2004–2015. Our findings suggest that the effects on the exchange rate are short-lived and significant only when banking constraints are binding. To understand the mechanism behind this result we construct a tractable two-period general equilibrium model in which banking limits on foreign holdings inhibit capital flows. When these limits bind, departures from the uncovered interest rate parity enable sterilized foreign exchange interventions to influence the exchange rate.
ISSN:0261-5606
1873-0639
DOI:10.1016/j.jimonfin.2019.05.008