On Effects of Interest Rates and Credit Constraints to Investor Funding Positions in a Multi-Currency Economy

Abstract

The currency composition of investors’ funding portfolios depends on the availability and price of credit in different countries and reacts to changes in these. I extend the global multi-country model of Gabaix and Maggiori (2015) to include currency-specific interest rates to analyze the network effects of changing funding conditions. Both increasing interest rates and tightening credit conditions in a given funding country make the currency less desirable as a funding source. As investors buy the currency to unwind their short positions, the currency value increases. The main result of this paper is that rising interest rates and tightening credit conditions in another funding country have opposite, to each other, effects on investor positioning. Assuming a positive trade correlation between two funding countries, increasing interest rates in one of the countries result in increased investor funding positions in the other country’s currency, as it has become cheaper vis-a-vis its alternative. However, tightening credit conditions in one of the funding countries result in decreased credit limits for the other country as well, so that investors unwind their positions in both countries. I present empirical evidence on Japanese Yen returns vs. other funding currency candidates that align with model propositions.

Keywords: Monetary policy, foreign exchange, international finance

JEL Classification: F31, F42, E51