# **E.** **<mark>The Risk-Taking Channel of Exchange Rate Appreciation</mark>**

Following Borio and Zhu (2012) and Bruno and Shin (2015a, 2015b), in this section, we briefly explore the risk-taking channel of financial conditions and monetary policy in developed countries via exchange rate appreciation. As described earlier, Bruno and Shin (2015b) argue that looser financial conditions are associated with an increase in cross-border capital flows intermediated through higher leverage in the international banking system. The mechanism operates via stronger local borrower balance sheets as a result of local currency appreciation, allowing banks to lend them more and take on more risk.

We test whether this risk-taking channel is active for international investors and external bond issuance as well. Under that hypothesis we would expect U.S. Dollar depreciation/local currency appreciation to be associated with a higher propensity for country-industries to be able to issue higher external bond volumes, all else equal.

We use two exchange rate variables as global push factors, following Bruno and Shin (2015a, 2015b):

- The 6-month log difference of the U.S. real effective exchange rate (USREER), along the lines of the VAR framework in Bruno and Shin (2015b). USREER is a trade-weighted Dollar index. Higher values imply a real depreciation of trade partner currencies (appreciation of the U.S. Dollar).

- The 6-month log difference of the real U.S. Dollar – Local currency exchange rate (XRATE), which is similar to the panel regression setting in Bruno and Shin (2015a). XRATE reflects the real bilateral exchange rate where higher values indicate a real depreciation of the local currency (appreciation of the U.S. Dollar). We use the 6-month log difference of the real exchange rate which is calculated as the log of the nominal exchange rate multiplied by the U.S. CPI and divided by the local CPI.

Table 7 presents the results. Analogous to Table 4, Models 1 and 2 estimate Equation (1) and provide strong support for the risk-taking channel of exchange rate appreciation hypothesis: the coefficients on USREER and XRATE are negative and highly statistically significant<sup>5</sup> . This indicates that the propensity to issue bonds externally above historical average volumes for a particular country-industry is significantly higher when the U.S. Dollar depreciates in real terms in the 6 months prior. In other words, when the local currency appreciates, local borrowers’ balance sheets strengthen. This in turn increases their external borrowing capacity which triggers higher cross-border flows by international investors who are willing to take on more risk.

These results are closely tied to our findings in Table 4 of the impact of the VIX on external bond issuance volume discussed in Section A. Particularly, the results point to a channel through which the VIX operates since Bruno and Shin (2015b) document a link between the VIX and USREER.

> 5 We are aware that there may be potential endogeneity issues in that the local currency appreciation could also be the _result_ of capital inflows. While the use of the 6-month prior exchange rate difference should help to address this issue, we leave it to future work to examine it further.

18