Bank Balance Sheets and External Shocks in Asia: The Role of FXI, MPMs and CFMs

In emerging Asia, banks constitute the dominant source of financing consumption and investment, and bank balance sheets comprise large gross FX assets and liabilities. This paper extends the DSGE model of Gertler and Karadi (2011) to incorporate these key features and estimates a panel vector autoregression on ten Asian economies to understand the role of the banking sector in transmitting spillovers from the global financial cycle to small open economies. It also evaluates the effectiveness of foreign exchange intervention (FXI) and other macroeconomic policies in responding to external financing shocks. External financial shocks affect net external liabilities of banks and the exchange rate, leading to changes in credit supply by banks and investment. For example, a capital outflow shock leads to a deprecation that reduces the net worth and intermediation capacity of banks exposed to foreign currency liabilities. In such cases, the exchange rate acts as shock amplifier and sterilized FXI, often deployed by Asian economies, can help cushion the economy. By contrast, with real shocks, the exchange rate serves as a shock absorber, and any FXI that weakens that function can be costly. We also explore the effectiveness of the monetary policy interest rate, macroprudential policies (MPMs) and capital flow management measures (CFMs).