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Against this background, when interest rates decline at home, U.S.-based lenders can search for yield in dollars abroad, driving up cross-border lending. And, when U.S. interest rates fall, a weaker dollar brightens the balance sheets of non-U.S. firms with U.S. dollar borrowing. The resulting improvement in their net worth expands their financing capacity. Not surprisingly, these destabilizing influences reverse when U.S. interest rates rise, sometimes leading to unpleasant surprises for foreign policymakers. Indeed, in a recent paper, Diamond, Hu and Rajan discuss how, through this mechanism, U.S. dollar depreciation can lead to credit booms and busts in other countries.
Given this large pro-cyclical (and potentially disruptive) role of the dollar in private financing, what can policymakers outside the United States do to secure financial stability? When Fed easing increases leverage in their economies, non-U.S. policymakers could respond by tightening domestic monetary policy. The effect, however, may be perverse: attracting capital inflows that lead to additional currency appreciation and drive borrowing capacity and leverage up even further.
As a consequence, authorities are more likely to use prudential measures to counter the financial risks from Fed policy spillovers. These prudential actions usually involve a mix of three policy categories:
high capital requirements on financial firms that restrict leverage
limits on borrowing by the nonfinancial sector (such as loan-to-value or debt-service to income restrictions on households or leverage limits on firms)
restrictions on cross-border financial flows
To be effective, the prudential policy framework needs to be comprehensive, or activities will escape the regulatory perimeter. It also needs to be put in place before the spillovers from expansionary U.S. monetary policy become large. Unfortunately, the effectiveness of prudential restrictions in good times (when falling dollar interest rates make credit plentiful)—and their benefits—usually become clear only in bad times (when rising dollar interest rates bring currency depreciation and diminished credit supply making it difficult for borrowers to roll over maturity debt). Reflecting an old financial market adage, we learn who’s swimming without a suit only when the tide goes out.
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