Keywords: Exchange rate regime, Debt composition and Hedging

Abstract:

This paper develops a model of the firm’s choice between debt denominated in local currency and that denominated in foreign currency in a small open economy characterized by exchange rate risk and hedging possibilities. The model shows that the currency composition of debt and the level of hedging are endogenously determined as optimal firms’ responses to a tradeoff between the lower cost of borrowing in foreign debt and the higher risk of such borrowing due to exchange rate uncertainty. Both the composition of debt and the level of hedging depend on common factors such as foreign exchange rate risk and the probability of financial default, interest rates, the size of firms’ net worth, and the costs of managing exchange rate risk. Results of the model are broadly consistent with the lending and hedging behavior of the corporate sector in small open economies that recently experienced currency crises. In particular, unlike the predictions of previous work in the literature on currency crises, the model can explain why the collapse of the fixed exchange rate regime in Brazil, in early 1999, caused no major change in the currency composition of debt of the corporate sector.

1 Introduction

Recent currency crises in East Asia and Latin America have been characterized by currency mismatches between assets and liabilities, as well as inadequate hedging, in the balance sheets of the corporate sector. 1 Some researchers have argued that the mismatch between foreign currency liabilities and domestic currency assets in firms’ balance sheets has been the root cause of the large output collapses following currency depreciations (Krugman, 1999; Aghion, Bacchetta, and Banerjee, 2001; and Schneider and Tornell, 2000). Under a fixed exchange rate regime, firms view fixed exchange rates as a guarantee and thus fail to insure their foreign exposure. 2 A direct implication of this line of reasoning is that once the exchange rate is allowed to float, firms will recognize their exposure, and foreign currency loans will be viewed as more costly so that firms will reduce their currency mismatches by downsizing their foreign currency borrowing. Contrary to this prediction, firm-level evidence from Brazil over the period 1997-2001 suggests that the collapse of the fixed exchange rate regime in 1999 caused no major change in the currency composition of corporate-sector debt. This paper attempts to explain this apparently surprising result.

To study this phenomenon, the paper develops a theoretical framework that examines the firm’s choice of local and foreign currency debt in the presence of exchange rate risk and hedging possibilities. The model shows that decisions about the currency composition of debt and the optimal level of hedging are interrelated and depend on common factors such as exchange rate risk and the probability of financial default, interest rates, the size of firms’ net worth, and the costs of managing foreign currency risk. The key element driving the model’s results is the tradeoff that firms face between the lower cost of borrowing in foreign currency and the higher risk of such borrowing due to exchange rate uncertainty. When affordable, hedging reduces firms’ exposure to currency risk and expands their capacity for borrowing in foreign currency. Thus, after a large currency depreciation—say, the collapse of a fixed exchange rate regime—hedged firms are able to maintain or even increase their access to foreign currency borrowing.

In the model, forward-looking firms make their borrowing decisions based on expectations of currency depreciation. Thus, even under fixed exchange rates, as long as such firms perceive that the regime is no longer credible, they will anticipate a future depreciation and will start managing the devaluation risk by engaging in hedging activities. As seen in section 2, this strategy seems to have been pursued by some firms in Brazil, which were hedged with currency derivatives even during the fixed exchange rate regime. Furthermore, when financial markets provide enough tools to mitigate the effects of the devaluation risk, the collapse of the fixed exchange rate may cause only small changes in the currency composition of debt because, given the opportunity to hedge, companies may not reduce their foreign currency debt after the devaluation.

The model’s predictions are broadly consistent with the lending and hedging behavior of corporations in small open economies that recently faced currency crises. The theory advanced by the model suggests that, when the economy moves from fixed to floating exchange rates, some firms change their financing policies, and the population of firms exposed to foreign exchange risk is altered. Firms with insufficient net worth and those unable to afford a hedge lose access to capital markets. Firms with high enough net worth and those with an ability to hedge increase their foreign debt. Firms that have intermediate net worth but are unable to hedge borrow less in foreign currency, turn to domestic banks, and are monitored by such banks to maintain their access to foreign capital markets. In a macroeconomic environment characterized by a moderate probability of currency depreciation and inexpensive hedging, these changes in the population of firms can offset each other so that the average currency composition of debt varies little across regimes.

The paper builds on the Holmstrm and Tirole (1997) model of credit extended to the small open economy. The analytical framework most closely related to this paper is that of Martinez and Werner (2002). They also adapt the model of Holmstrm and Tirole to the case of the small open economy and find that before the Mexican crisis of 1994, the decision to borrow in pesos or dollars depended on the exchange rate regime to the extent that the government provided an implicit guarantee by fixing the exchange rate. However, the authors treat the exchange rate as a deterministic variable, and no hedging strategies are discussed. In their model, as in most of the previous literature, large amounts of foreign currency debt implicitly represent higher exposure to exchange rate risk.

As mentioned earlier, previous theoretical models suggest that a large devaluation has a negative effect on companies’ foreign currency borrowing and that it reduces currency mismatches. However, empirical findings on the relationship between exchange rate regimes and currency mismatches in corporate-sector balance sheets are mixed and still subject to debate. Some studies find that the adoption of a floating regime reduces currency mismatches by decreasing foreign currency borrowing and increasing levels of hedging, whereas others find that firms borrow even more after a currency crisis. 3 As Cowan, Hansen, and Herrera (2005) point out, many of the previous studies use the ratio of foreign debt to total debt as an exogenous proxy for currency mismatches. Using data from corporations in Chile, the authors argue that the lack of empirical consensus about the importance of balance sheet effects results from the endogeneity of the currency composition of debt and not from the absence of such effects. The model in the current paper accounts for the endogenous determination of both the level of hedging and the currency composition of debt and helps explain the apparent contradiction between theory and empirical evidence. 4 As demonstrated in the model, hedging allows corporations, in the aggregate, to maintain their access to international capital markets and to keep their currency composition of credit almost unchanged after a currency crisis.

The reminder of the paper is organized as follows. Section 2 outlines the motivating empirical facts for the model, using firm-level data from Brazil. Section 3 describes the model of optimal debt allocation and hedging at the firm level. Section 4 offers the main results of the model under fixed and flexible exchange rates. Section 5 concludes the paper.

2 Empirical Evidence on Foreign Currency Exposure and Hedging: Brazil, 1997-2001

This section examines firm-level data on Brazilian firms for the period 1997-2001, which covers the two years before the currency crisis of 1999, the two years after, and the crisis year itself. Like other Latin American countries, Brazil suffered unexpected reversals in capital flows after earlier crises in Mexico (1994), East Asia (1997), and Russia (1998). In Brazil, the macroeconomic adjustment caused by substantial capital outflows at the end of 1998 brought large and persistent swings in the exchange rate that finally led to the collapse of the crawling peg and a sharp devaluation of its currency, the real. in January 1999.

Firm-level data consist of financial information for a balanced panel of 145 nonfinancial companies that were publicly traded on the So Paulo Stock Exchange (BOVESPA) over the period 1997-2001. 5 The information was taken directly from companies’ annual financial reports. Data contain information on balance sheet variables such as the book value of assets, the currency composition of debt, and shareholders’ equity. Data on hedging transactions were hand-collected and consist of the year-end notional value of currency derivatives (forwards, futures, swaps, and options), as reported in the explanatory notes to financial statements available at BOVESPA. Financial and state-owned firms are excluded because of their different motivation for using currency derivatives.

Table 1 illustrates the currency composition of firms’ debt and the extent of their hedging activities across exchange rate regimes. As shown in the table, when the Brazilian economy moved from a fixed to a floating exchange rate regime, there was no major change in the currency composition of debt, measured by the ratio of foreign debt to total debt. 6 Over the sample, the ratio remains stable at around 43 percent. Across firms grouped by size, the foreign debt ratio seems to exhibit a similar pattern except for small firms that, on average, slightly decrease their ratios. In contrast, the extent of hedging operations, approximated by the ratio of the notional value of currency derivatives to foreign debt, increased from 5 percent in 1997 to 25 percent in 2001. Interestingly, the data show that hedging operations increased during the floating exchange rate regime but had already been observed during the fixed exchange rate period, especially for medium and large corporations. Large companies increased their hedging ratio, on average, from 6 percent during the fixed exchange rate regime to 22 percent during the floating regime. The observation of hedging activities under fixed exchange rates indicates that even before the currency crisis, and most likely after crisis episodes in East Asia and Russia, some firms indebted in foreign currency were managing the devaluation risk by hedging their positions with currency derivatives. As will be shown later, this behavior is consistent with the model’s predictions concerning the hedging features of financing policies in small open economies subject to currency risk. Table 1 also suggests some evidence of costly hedging, as the increase in the hedging ratio occurred mostly at large and medium-sized companies, whereas small firms appear to have hedged only a small fraction of their foreign debt, even during the floating regime. 7

An interesting feature regarding the hedging behavior of the corporate sector in Brazil is that most financial hedging transactions involve currency swap contracts. Unlike large U.S. nonfinancial corporations, which report currency forwards and options as the most commonly used tool to manage exchange rate exposure, similar Brazilian firms seem to prefer currency swaps, which effectively convert foreign debt into domestic debt through simultaneous transactions in the spot and forward markets. Broad preference for currency swaps is also consistent with costly hedging, as a swap reduces transaction costs by allowing companies to arrange with only one contract what may otherwise take several transactions (for example, forward contracts) to replicate. 8

Table 2 shows the number of firms that held financial debt (in domestic currency, foreign currency, or both), and the number of such firms that used currency derivatives, over the sample period. These data also provide evidence of minor changes in the corporate sector’s borrowing behavior. Some firms dropped out of the sample, and the number of firms that borrowed only in domestic currency increased slightly during the floating regime. After the collapse of the exchange rate regime, the number of firms that hedged with currency derivatives increased from 7 in 1997 to 40 in 2001. Interestingly, about 46 percent of the firms with foreign debt remained unhedged in 2001. Overall, the evidence presented in this section seems to support the view that no significant changes occurred in the borrowing patterns of the Brazilian corporate sector during the period 1997-2001—that is, before, during, and after the currency crisis. Admittedly, obtaining a genuine measure of the extent of firm-level hedging is difficult, and the previous observations about hedging refer only to the use of currency derivatives. Firms may use hedging strategies other than derivatives, such as holdings of assets denominated in foreign currency and revenues from exports, which are not examined in the current analysis. That said, one point can be emphasized: The evidence from the sample of Brazilian firms is contrary to the results predicted in previous research. After the large depreciation that followed the collapse of the fixed exchange rate regime, firms still borrowed significantly in foreign currency, and more companies hedged this debt by participating in currency derivatives markets. As shown in the next section, the model’s predictions of optimal debt composition and hedging levels are consistent with these empirical facts.

3 A Model of the Optimal Currency Composition of Debt and Hedging

Consider a small open economy described by a two-date model ( ). The economy is populated by a continuum of risk-neutral firms, domestic banks, and foreign banks. Firms are run by wealth-constrained entrepreneurs who need to raise funds to cover their investment outlays. Firms’ investment projects can be financed by borrowing in either domestic currency from local banks or in foreign currency from foreign banks. Given the uncertainty about the exchange rate, firms can choose to hedge their foreign exchange risk by signing forward contracts offered by local banks. At . firms sign debt contracts and make investment, borrowing and hedging decisions. At . exchange rate and investment returns are realized and claims are settled. Agents are protected by limited liability so that no party can end up with negative payoffs.