A Hedge, Not a Bet

• Author: Herman Kamil / Bennett W. Sutton / Chris Walker
• Position: Economist / Senior Research Officer / Senior Economist in the IMF’s Western Hemisphere Department
• Pages: 46-47

Page 46

Latin American companies used new techniques to protect against currency swings. But a few used them to gamble—and lost big

BORROWING in foreign currency can be a double-edged sword for companies in emerging markets. Foreign currency liabilities often give firms the ability to secure funding at a lower cost and at longer maturities than if they borrowed in their domestic currency. But those same liabilities can leave balance sheets vulnerable to swings in exchange rates. In the late 1990s and early this decade, sharp currency depreciations in several countries in Latin America 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 have faced higher day-to-day fluctuations in exchange rates as many countries sought greater exchange rate flexibility. Those more flexible rates provided for better adjustment to external shocks and allowed monetary policy more independence. Crucially, it also provided incentives for firms to better manage their currency risk because they no longer could rely on central banks to keep currency movements within a preannounced range. What had been essentially free currency risk insurance to the private sector ended.

In a recent study (International Monetary Fund, 2008) we looked at the vulnerability of the corporate sector in Latin America to exchange rate changes between 1994 and 2007. We found that firms have sharply cut their balance sheet exposure to a sudden devaluation by reducing the share of debt contracted in foreign currency. We also found that firms have been more actively using “natural” currency hedges (export proceeds and dollar assets) to offset the dollar risk arising from their debt portfolio. But after the bankruptcy of Lehman Brothers in September 2008, a new vulnerability became apparent. Some firms (especially larger, more sophisticated ones) had used financial derivative contracts to place bets on currency movements—and lost big when the currencies depreciated steeply. That not only led to financial problems for the companies, but presented authorities with difficult issues in foreign exchange markets.

Stronger balance sheets

To examine corporate sector vulnerability, we drew on a new database that links corporate balance sheet and stock market data for 1,200 publicly traded firms (financial and nonfinancial) in Argentina, Brazil, Chile, Colombia, Mexico, and Peru. We first...