The Dollar Exchange Rate as a Global Risk Factor: Evidence from Investment

Abstract

Exchange rate fluctuations influence economic activity not only via the standard trade channel, but also through a financial channel, which operates through the impact of exchange rate fluctuations on borrowers' balance sheets and lenders' risk-taking capacity. This paper explores the "triangular" relationship between (i) the strength of the US dollar, (ii) cross-border bank flows and (iii) real investment. We conduct two sets of empirical exercises - a macro (country-level) study and a micro (firm-level) study. We find that a stronger dollar is associated with lower growth in dollar-denominated cross-border bank flows and lower real investment in emerging market economies. An important policy implication of our findings is that a stronger dollar has real macroeconomic effects that go in the opposite direction to the standard trade channel.

Keywords: financial channel, exchange rates, cross-border bank lending, real investment

JEL Classification: F31, F32, F34, F41