Analysis Of The Impact Of Currency Mismatch On Credit On The Effectiveness Of Monetary Policy

In recent years, several currency crises with major influence have happened in emerging market countries. From the debt crisis which swept through Latin America of in1980s to the Mexican currency crisis occurred in1990s, the Southeast Asian financial crisis, and then the Argentine peso crisis at the end of2001, these countries showed no indication of serious economic problems and exchange rate instability before the outbreak of the crises, and less necessity of currency devaluation. These features can not be explained by the crisis model of the first generation and second generation. So, the problem of currency mismatch shared by those crises happened countries has come into the perspective of the researchers.Currency mismatch refers to an interest entity’s balance sheet is denominated with different currencies, and leads its net worth or net income (or both) to be very sensitive to exchange rate fluctuations. It can be further divided into the currency mismatch on debt and the currency mismatch on credit. According to the process of a country’s economic development, developing countries will experience these two phases in general. At the early stage of development, the current account shows a deficit, and lacks of investment, many countries make up part of the margin through external borrowing and thus formed a currency mismatch on debt. They face the risk of debt growth which will lead to domestic currency devaluation. With the increase of national strength, the debtor countries gradually shift into creditor countries and consequently formed the currency mismatch on debt, and face with the pressure of domestic currency appreciation. Domestic currency appreciation will not only lead to the loss of assets caused by exchange rate fluctuations, trade losses and deflation, but also damage the effectiveness of monetary policy in a country.This paper focuses on currency mismatch on credit. From angles of exchange rate, money supply and interest rate, using combined methods of theoretical analysis and practical case study to explore how the effect of currency mismatch on credit affects the under the effectiveness of a country’s monetary policy. First of all, this paper does theoretical analyses from the perspectives of the exchange rate, money supply and interest rate. The country with currency mismatch on credit faces enormous pressure of domestic currency appreciation. The appreciation of exchange rate will lead to asset substitution effect, Balance Sheet Effect, Competitiveness Effect, and these three effects will result in the loss of net foreign currency assets. In addition, with the currency mismatch on credit, the huge sum of foreign exchange reserves not only makes a country’s money supply become passive but also makes its money multiplier becomes unstable. From the perspective of interest rate, under the pressure of domestic currency appreciation, in order to keep a fixed combination of the private sector’s domestic currency assets and foreign currency assets and to prevent the inflow of "hot money", the central bank reduces the anticipation of currency appreciation by decreasing interest rate, but if they doing so there will be risk of falling into liquidity trap. Therefore, analyses of these three different perspectives show that a country’s currency mismatch set up many limitations and obstacles to a country’s monetary policy. Secondly, the practice and monetary policy issued by Japan as a typical country with currency mismatch on credit in the1970s to the1990s provide a reference for China. This paper focuses on three important agreements signed by Japan, three major currency appreciation stages and three major unsuitable monetary policies, combines with the above theoretical analyses of exchange rates, money supply and interest rate to sum up the reasons for its falling into liquidity trap and sustained economic recession, compares with China’s currency mismatch in current situation, and provides policy advices. Finally, based on the foregoing analyses and the current features of China’s currency mismatch on credit, combined with the preceding theoretical analysis and the experience of Japan, this paper makes recommendations for maintaining the effectiveness of monetary policy.