Foreign Currency Debt and Fixed Exchange Rate Regimes: the importance of implicit guarantees against currency devaluations

Since the mid 1990s, theories of speculative attacks have argued that fixed exchange rate regimes induce excessive borrowing in foreign currency as an optimal response to implicit guarantes that the government will not devalue the domestic currency. Using data on Brazilian firms before and after the end of the fixed exchange rate regime in 1999, we estimate the relevance of the implicit guarantees by comparing the changes in foreign debt of two groups of firms: those that hedged their foreign currency debt prior to the exchange rate float and those that did not. Using the difference-in-differences approach, in which firm-specific characteristics are introduced as control variables, we exclude macroeconomic effects of the change in the exchange rate regime and possible differences in foreign debt trends of the two groups of firms, thus obtaining an estimate of the impact of the implicit guarantees on borrowing in foreign currency. The results suggest that the implicit guarantees do not induce excessive borrowing in foreign currency.