Working Paper: NBER ID: w28096
Authors: Viral V. Acharya; Siddharth Vij
Abstract: We establish that macroprudential policies limiting capital flows can curb risks arising from corporate foreign currency borrowing in emerging markets. Using detailed firm-level data from India, we show that propensity to issue foreign currency debt for the same firm is higher when the difference in short-term interest rates between India and the US is higher, i.e., when the dollar ‘carry trade’ is more profitable; this behavior is driven by the period after the global financial crisis. The positive relationship between issuance and the ‘carry trade’ breaks down once regulators institute more stringent interest-rate caps on foreign currency borrowing. Riskier borrowers such as importers and those with higher interest costs cut issuance most. Firm equity exposure to foreign exchange risk rose after issuance in favorable funding conditions and emerged as a source of external sector vulnerability during the ‘taper tantrum’ of 2013. Macroprudential policy action limiting capital flows is able to nullify this effect, such as during the market stress due to the COVID-19 pandemic.
Keywords: Foreign currency borrowing; Carry trades; Macroprudential policies; Emerging markets; Corporate finance
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 |
|---|---|
| higher implied interest expenses (E43) | firms reduce their borrowing (G21) |
| favorable funding conditions (G32) | firms' equity exposure to foreign exchange risk increases (F31) |
| market stress events (G14) | vulnerabilities increase for firms (G32) |
| macroprudential policies limiting capital flows (F38) | risks from corporate foreign currency borrowing (F65) |
| carry trade profitability (G15) | propensity for firms to issue foreign currency debt (F31) |
| introduction of stricter interest rate caps by RBI (G21) | positive correlation between foreign currency debt issuance and carry trade profitability (G15) |