Currency Portfolio of External Debt, Exchange Rate Cyclicality, and Consumption Volatility

38 Pages Posted: 20 May 2020

See all articles by Eiji Fujii

Eiji Fujii

Kwansei Gakuin University - School of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: 2020

Abstract

Even though external debt can play a buffer role against adverse shocks to assist consumption smoothing, it may also exert a volatility amplifying effect, depending on the currency of denomination and the cyclicality of the borrower's exchange rate. We empirically investigate the nexus between the debt denomination portfolio, exchange rate cyclicality, and consumption volatility of low- and middle-income countries. On constructing the debt-weighted effective exchange rates, we examine how the denomination portfolio affects the debtors' exchange rate cyclicality to influence the consumption response to transitory income shocks. We find that portfolio concentration enhances exchange rate pro-cyclicality, which makes consumption more volatile when income shocks occur. Our results suggest that portfolio diversification is a useful tool for countries with original sin to hedge against bumpy consumption paths.

Keywords: external debt, currency portfolio, original sin, exchange rate cyclicality, consumption volatility

JEL Classification: F340, F310

Suggested Citation

Fujii, Eiji, Currency Portfolio of External Debt, Exchange Rate Cyclicality, and Consumption Volatility (2020). CESifo Working Paper No. 8287, Available at SSRN: https://ssrn.com/abstract=3603844

Eiji Fujii (Contact Author)

Kwansei Gakuin University - School of Economics ( email )

1-155 Uegahara Ichiban-cho
Nishinomiya
Japan

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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