Working Paper: CEPR ID: DP15440
Authors: Viral V. Acharya; Siddharth Vij
Abstract: We establish that macroprudential policies limiting capital flows can curb risks arisingfrom corporate foreign currency borrowing in emerging markets. Using detailed firm-level data from India, we show that propensity to issue foreign currency debt for thesame firm is higher when the difference in short-term interest rates between India andthe US is higher, i.e., when the dollar ‘carry trade’ is more profitable; this behavior isdriven by the period after the global financial crisis. The positive relationship betweenissuance and the ‘carry trade’ breaks down once regulators institute more stringentinterest-rate caps on foreign currency borrowing. Riskier borrowers such as importersand those with higher interest costs cut issuance most. Firm equity exposure toforeign exchange risk rose after issuance in favorable funding conditions and emerged asa source of external sector vulnerability during the ‘taper tantrum’ of 2013.Macroprudential policy action limiting capital flows is able to nullify this effect, such asduring the market stress due to the COVID-19 pandemic.
Keywords: emerging markets; foreign currency debt; foreign exchange risk; taper tantrum
JEL Codes: F31; F34; G15; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| difference in short-term interest rates between India and the US (E43) | propensity of firms to issue foreign currency debt (G15) |
| stricter interest rate caps on foreign currency borrowing (F31) | issuance among riskier borrowers (G21) |
| introduction of macroprudential policies (E60) | positive relationship between foreign currency borrowing and carry trade profitability (G15) |
| most firms' equity exposure to foreign exchange risk rises after issuance during favorable funding conditions (F31) | source of vulnerability during market stress (E44) |
| macroprudential policy actions limiting capital flows (F38) | risks associated with corporate foreign currency borrowing (F65) |