Working Paper: NBER ID: w26545
Authors: Hui Tong; Shangjin Wei
Abstract: A country may adopt policy measures such as raising its foreign exchange reserves to better prepare for foreign interest rate shocks or sudden reversal of international capital flows, which in principle should reduce financial vulnerability for its firms and the entire economy, but the beneficial effect of such policies may be partially offset by endogenous firms’ decisions to take on more risks. We present a robust but previously undocumented relationship between corporate leverage and country-level foreign exchange reserve holdings. For 6610 non-financial firms in 23 emerging markets from 2000 to 2006, we show that more foreign reserve accumulation leads to higher corporate leverage. While the reserve accumulation can reduce macroeconomic uncertainty, the increase in corporate leverage is also significantly greater in sectors that are intrinsically more sensitive to policy uncertainty. We go from correlation to causality via a two-prong instrumental variable strategy: simultaneously (1) instrumenting FX reserves by global commodity price movement, and (2) examining leverage of firms outside the commodity-sensitive sectors.
Keywords: Corporate Leverage; Foreign Exchange Reserves; Emerging Markets; Macroeconomic Policy
JEL Codes: F3; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign exchange reserves (F31) | corporate leverage (G32) |
| foreign exchange reserves (F31) | macroeconomic uncertainty (D89) |
| macroeconomic uncertainty (D89) | corporate leverage (G32) |
| foreign exchange reserves (F31) | corporate leverage (sensitive sectors) (G32) |
| corporate leverage (G32) | vulnerability to negative shocks (F65) |