Firms that contract debt in foreign currency rather than in domestic currency can create currency exposures via balance sheet mismatches. These currency exposures can potentially lead to more costly external financing, or even bankruptcy when the exchange rate depreciates sharply. There-fore the currency composition of corporate debt is an important capital structure decision.
In this paper I use a panel dataset of Mexican firms traded on the Mexican Stock Market in the last 10 years. I document two stylized facts about firms in the non-tradable sector: (i) they take on large amounts of dollar-denominated debt and (ii) their earnings, defined as sales minus costs and financing expenses, are not sensitive to the exchange rate. The first stylized fact is consistent with the emerging markets literature, where mounting empirical evidence shows that firms in emerging markets have a sizable amount of dollar-denominated debt. The second empirical fact suggests that firms are managing their currency exposure.
Several explanations for the high dollar indebtedness have been offered in the theoretical literature. Schneider and Tornell (2004) argue that implicit guarantees by the government induce firms to borrow in dollars excessively. Expecting a bailout in the event of a large currency depreciation, firms overexpose themselves to exchange rate fluctuations. The implicit guarantees by the government provide some benefit to issuing large amounts of dollar debt. Caballero and Krishnamurthy (2001, 2003) argue that limited financial development in emerging markets led to firms taking on excessive dollar debt. Specifically they show that when financial constraints affect borrowing and lending, firms undervalue insuring against an exchange rate depreciation and therefore take on excessive dollar debt.
Both of these theories are based on the existence of benefits to issuing dollar debt, which firms balance against the cost in the event of a large currency depreciation. In these models currency mismatches of assets and liabilities arise in equilibrium, and therefore firms’ profits are exposed to fluctuations in the exchange rate. These theories are consistent with the first stylized fact of high dollar indebtedness. However they are in contradiction with the second stylized fact that earnings of Mexican firms are not exposed to the exchange rate.
In this paper I propose an explanation that reconciles the seemingly contradictory empirical facts that firms in the non-tradable sector issue large amounts of dollar debt but are hedged against currency risk. I develop a model of firms in an open economy and show that non-exporting firms are exposed to exchange rate risk because of the exporters in the economy, and that they hedge their currency exposure using dollar debt. In the model, high dollar indebtedness is a direct result of an optimal financing decision.
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Pass-through, Exposure, and the Currency Composition of Debt
