Given the severity of the current financial turmoil and the drought of funding that corporations, both financial and non-financial, are facing all over the world, it becomes more and more relevant how exposed are companies in Latin America specially considering the trend towards more flexible exchange rate regimes in the last decade, and the resulting higher exchange rate volatility.
Foreign currency borrowing has been relatively appealing for corporations in many developing economies as it could possibly allows firms to borrow at lower rates and usually for longer maturities than those available on local debt markets. Nonetheless, most of the benefits are counter-balanced by an increased exposure to sudden currency swings, and thus large movements on companies’ balance sheets.
Herman Kamil and Bennett Sutton are the authors of Chapter V of IMF’s newly release Regional Economic Outlook for Latin America, which analyzes corporate vulnerabilities in the region. The chapter innovates as it brings a new methodology that goes beyond the analysis of companies spreadsheets to use a new micro-level database that links corporate balance sheets and stock market data for 1,200 publicly traded firms in Argentina, Brazil, Chile, Colombia, Mexico and Peru.
Looking at the share of foreign currency denominated liabilities among companies in those countries we can see a sharp increase during the 1990s up until more flexible exchange rate regimes were introduced. In the case of Brazil and Colombia, this trend was also seen, although levels were much lower due to reduced incentives to dollarization in those two countries. The data also shows that not only has the share of foreign currency denominated liabilities decreased when of the introduction of more flexible exchange rate regimes but companies have also increased efforts to better match foreign currency debt to their foreign currency revenues, aside from building up considerable foreign exchange buffers, reducing their overall vulnerability.
But the impact of significant currency swings over companies goes beyond the foreign exchange liabilities held, extending into much more complex and ambiguous effects such as imported intermediate inputs, multinational operations, competition with foreign firms in low markup marketplaces and also the use of financial derivatives. With this in mind, the authors advance into an approach where weekly stock-market returns of financial and non-financial firms are contemporaneously compared to exchange rate movements. The study basically compares the percentage change in a firm’s stock-market price following a 1 percent depreciation of the nominal effective exchange rate – comparing those responses in two distinct periods, 1995-98 and 2004-07 yields the following conclusions:
– The fraction of firms exposed on the 2004-07 period decreased in all countries vis-à-vis the 1995-98 period and when market capitalization is considered, exposure has fallen more than proportionately suggesting that the insulation increased even more among bigger companies with better access to derivative markets.
– For firms that remained exposed, the degree of exposure was decreased. For example, in Mexico during the 1995-98 period, a 1 percent depreciation would cause an average 2 percent fall in equity price, while that same depreciation in the 2004-07 period represented only an average loss of 1.1 percent in equity. Price.
– The nature of the exposure has shifted positively. In the early sub-period, the majority of firms would see a loss in equity prices due to a depreciation, while on the most recent period a significant share of companies would actually see equity price gains in response to a currency depreciation.
The study clearly shows that corporations were able to manage the potential increase in vulnerability through use of different strategies, in special currency derivatives. The authors argue that in Colombia, it is clear that forward contracts were used strictly to hedge company’s exposure to foreign exchange rate swings while in Brazil and Mexico, where swaps and options are more widely used, the evidence becomes more sparse on whether those instruments were used for protection or for speculation. It is very possible that off-balance-sheet operations with derivatives used for speculative purposes as opposed to hedging purposes do increase the risk exposure. More recently some firms in Brazil and Mexico have incurred significant losses on foreign currency derivative positions due to large depreciations in September and October 2008. Increased information disclosures on those operations are certainly needed as a step towards improved transparency and thus safety of the corporate environment in those countries.