Foreign Exchange exposure, corporate financial policies and the exchange rate regime: Evidence from Brazil

Abstract Recent financial crises showed that emerging countries are extremely vulnerable to sudden swings in international capital flows. In these countries, commonly, periods of relative tranquility, characterized by substantial capital inflows and real GDP growth, are followed by periods when capital flows abroad, and output plummets . In some countries, such crises led not only to economic downturns but also to social unrest. Although there is a consensus among economists that emerging markets should take measures to reduce their external vulnerability, there is no agreement about the role of the choice of the exchange rate regime in this matter. At the center of this debate is the fact that due to the widespread problem of the dollarization of liabilities, depreciations of the home currency in emerging markets would cause a collapse in companies’ balance sheets, leading to a fall in output . Therefore, one mechanism through which the choice of the exchange rate regime could affect countries’ vulnerability would be to exert influence on corporate financial policies. One hypothesis in the international finance literature is that fixed exchange rate regimes would increase countries’ vulnerability by leading companies to disregard the exchange rate risk, biasing their borrowing towards foreign currency denominated debt , and/or reducing their hedging activities. According to this hypothesis, floating regimes would help to reduce countries’ vulnerability by inducing creditors and debtors to take seriously their exchange rate exposure. On the other hand, the so-called ‘original sin’ theory argues that, independently of the exchange rate regime, emerging countries will always be vulnerable to external shocks. There will always be a currency mismatch on companies’ balance sheets, since domestic companies would never be allowed to borrow in the domestic currency, and most of their revenues come from domestic activities. Since the theoretical literature has not reached a consensus, at the end of the day, the answer for this question should be empirical, as pointed out by Eichengreen and Hausmann (1999), ''...gathering survey (and other) data on hedged and unhedged exposures and analyzing their determinants should be a high priority for academics'' . This paper tries to shed light on this question by analyzing the behavior of foreign currency exposure for a sample of non-financial Brazilian companies from 1996 to 2002. This includes a period under a fixed exchange rate regime (1996-1998), and a period under a floating regime (1999-2002). I analyze whether companies’ exposure varies with the choice of the exchange rate regime. Moreover, I discriminate among the several determinants of companies’ exchange rate exposure, and finally I study the relationship among corporate financial policies, the choice of the exchange rate regime, and the exchange rate exposure. Brazil provides a perfect natural experiment for analyzing the relationship between foreign currency exposure and the choice of exchange rate regime in emerging markets. Brazil is one of the largest emerging markets economies, and had a fixed exchange rate regime from 1995 to January 1999. After that the currency was allowed to float freely, currency derivatives were available in both periods and companies kept substantial levels of foreign currency denominated debt. Finally, I know of no studies combining analysis of the exposure of companies, the determinants of that exposure and the role of the exchange rate regime in an emerging market economy in which fluctuations in the exchange rate and risk management policies are of major importance to the real economy. The main results can be summarized as follows. Fluctuations in the exchange rate are indeed problematic for emerging markets like Brazil; about 40% of Brazilian companies are exposed to changes in the exchange rate, and, unlike those in the US, Brazilian companies do not on average benefit from devaluations of the home currency. A 1% change in the exchange rate leads to a 0.22% fall in the average company’s stock market returns. This paper also shows that the floating exchange rate regime has been able to reduce such exposure. Under the fixed exchange rate regime about 60% of the companies are exposed to fluctuations on the real exchange rate; this proportion drops to 23% under the floating exchange rate regime. The results confirm that the high proportion of foreign currency denominated debt to total debt is the main source of risk for Brazilian companies, and that foreign sales and hedging activities are able to mitigate the negative exposure that comes from the impact of the fluctuations of the exchange rate on companies’ foreign liabilities. This paper also associates the reduction in the number of companies exposed to changes in the exchange rate with an improvement in companies’ risk management activities associated with the change of the exchange rate regime. Under the floating regime, not only do more companies hedge their exchange rate exposure, but these firms also hedge a larger proportion of their foreign currency denominated debt. Following the optimal hedging literature, I find that companies’ hedging activities are linked to the attempt to reduce their foreign currency exposure. Companies with higher ratio of foreign debt to total debt are more likely to use currency derivatives. Moreover, using a model developed by Holmstrom and Tirole (1997), and extended by Martinez and Werner (2003), I find that the fixed exchange rate regime induced companies to incur mismatches in their balance sheets, whereas the floating regime has been able to reduce such mismatches by leading companies to take seriously their exposure to fluctuations in the exchange rate.