Foreign currency financing has been a key source of financial vulnerability for companies in Latin America. In the 1990s and early this decade, sharp currency depreciations in several countries in the region drove up the value of firms’ foreign currency debt relative to their assets and income, impairing many firms’ ability to service debt. This, in turn, exacerbated the banking difficulties that many of these countries experienced.
Over the past decade, firms in many countries in Latin America have faced higher day-to-day fluctuations in exchange rates, as these countries now allow greater exchange rate flexibility to provide more independence to monetary policy. Moreover, by switching to more flexible regimes, countries have also removed the perception of implicit guarantees prevailing under pegged regimes. In a recent study, we look at how firms have managed currency risk in this new environment. This is especially important given the heightened exchange rate volatility and the sharp depreciation of currencies in the region in the past few two months.
The study draws on a new micro-level database that links corporate balance sheet and stock market data for 1,200 publicly traded firms in Argentina, Brazil, Chile, Colombia, Mexico, and Peru. The dataset provides detailed information on a firm’s share of assets, liabilities, and sales in foreign currency. With these data at hand, we first describe the evolution of firms’ net foreign currency positions over a relatively long time span (1992–2007). We complement this on-balance sheet analysis by exploring the sensitivity of firms’ stock market valuations to exchange rate changes. Stock prices’ reaction to exchange rate changes should, in principle, summarize the multiple channels through which exchange rate fluctuations can affect firms’ value.
The results show that firms have become, on average, substantially more insulated from currency risk in the more recent period. Over the past 10 years, many firms in the nonfinancial sector have sharply cut their balance sheet exposure to a sudden devaluation by reducing the share of debt contracted in foreign currency. The average share of foreign-currency-denominated liabilities in Latin America dropped from 35 percent in 1998 to 17 percent in 2007. Also, in all six countries, firms have built up considerable foreign exchange buffers, by hedging a higher share of their dollar liabilities with export revenues and assets denominated in foreign currency.
Using stock market return data, we find that for a significant fraction of firms, the impact of exchange rate changes on equity prices has declined considerably since mid-2000. The fraction of firms exposed to changes in currency movements decreased significantly in 2004–07 compared with 1995–98. A similar story holds for the average sensitivity of firms’ stock prices to exchange rate developments, which has also fallen in the most recent period. Moreover, the direction of exposure has also changed over time. During the first period, we find that the response of stock prices to exchange rate depreciations was overwhelmingly negative. By contrast, between 2004 and 2007, among those Latin American firms that remained exposed, a higher fraction (35 percent) now benefit from a depreciation of the domestic currency.
Yet balance sheet information only tells part of the story. Over the past decade, firms have increasingly been relying on financial derivatives to manage currency risk. The number of firms participating in currency-derivative markets has skyrocketed, rising roughly fivefold in Colombia and Chile in the last six years. In Brazil, on the other hand, 60 percent of the publicly-traded firms in 2006 used some form of currency derivative. Financial derivative positions are off– balance sheet, and often not reported or disclosed to investors.
A key question is whether currency derivatives are used to hedge exchange rate risk (i.e., to offset balance sheet exposures) or to speculate (i.e., take open foreign currency positions in hopes of adding to profits). Evidence for Colombia indicates that derivatives transactions have been used to effectively offset the foreign-currency risk created by on-balance-sheet mismatches (Kamil, Maiguashca, and Perez, 2008) rather than for speculative purposes. Yet recent developments in Brazil and Mexico indicate that some firms may have been using them for speculative purposes. Several corporations, some of them very large, incurred significant losses on foreign currency derivative positions when the exchange rate depreciated in October. In Peru and Chile, where forward currency markets have also grown significantly, there have been no reports thus far of significant losses associated to foreign exchange positions.
Overall, the empirical analysis provides evidence that the corporate sector has been proactive in reducing its vulnerability to exchange rate risk since the financial crises in the 1990s and early this decade. Three “buffering” forces appear to be at work. First, firms rely less on foreign currency liabilities and now depend more on domestic sources of local currency funding. Second, firms have been more actively using “natural” currency hedges to offset the dollar risk arising from their debt portfolios. Third, many firms have been making extensive use of foreign-currency derivatives to protect themselves from unexpected movements of exchange rates. A plausible interpretation of our results is that the trend in the region to adopt flexible exchange rates has given firms sufficient incentives to manage currency risk and be better prepared for currency shocks than they were during previous currency crises.
Yet the results presented in the study give no room for complacency. We find that significant currency exposures have become concentrated among smaller firms, which could be vulnerable to a sharp currency depreciation. Also, more work is needed to understand the effect of off-balance-sheet transactions on foreign exchange exposure of firms, especially in countries like Brazil and Mexico, where markets have become more liquid and off-balance-sheet activities can substantially alter the overall risk exposure at the firm-level. As financial derivatives become more sophisticated and complex, it is important for regulatory frameworks to adapt to market developments, along with reinforcing prudential supervisory practices.