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The double-edged sword of currency mismatches

Doing business in dollars has proved to be risky many times over in Latin America. When the price of the dollar goes up, local exporting companies increase their income and therefore try to export more. But that same exchange rate depreciation spells trouble to all companies indebted in dollars, and big trouble to the ones who owe money in dollars and have income in local currency.

There are few studies focusing on currency mismatches in emerging markets that use corporate data to explore the effects of dollar-denominated debt on companies' performances. During a seminar on currency mismatches at IDB headquarters, the Bank's Research Department presented a new database with detailed information on the currency and maturity composition of firms' assets and liabilities for 10 countries in Latin America.

Using this new database on Latin American companies' liabilities, IDB research economists Kevin Cowan and Arturo Galindo find large differences in the level of dollarization of firm liabilities across countries in the region. During the second half of the 1990's, the average firm in Argentina, Peru and Uruguay had more than half of its debt denominated in dollars. Firms in Brazil, Chile and Colombia, on the other hand, had relatively low levels of dollar denominated debt.

In addition, they find that in countries in which overall dollarization is low, companies usually match the currency composition of their liabilities with that of their incomes. In these countries companies holding debt in dollars are usually exporters or operate in the tradable sectors. In highly dollarized countries on the other hand, there is little difference across sectors in the levels of dollar debt. The net result, therefore, is that in the highly dollarized countries, firms producing local currency income end up with a mismatch between the currency of their incomes and that of their liabilities.

For those firms with a mismatch, depreciation spells financial trouble, as it makes the value of dollar debt grow relative to the firm's assets and income. To show just how problematic this mismatch is, Cowan and Galindo cited results from recent Research Network studies financed by the Bank. These studies, conducted by independent research teams in six countries, show that firms with large currency mismatches invest significantly less following depreciation.

According to scholar Herman Kamil from the University of Michigan at Ann Arbor, who recently published a review of the database, “its information is crucial if we are to adequately measure the level of currency mismatch and thus the effects of this exposure on output and investment.” Kamil adds that having access to “a precise measure of foreign currency exposure at the microeconomic and sector levels across a wide range of countries is (…) extremely important because the possible presence of negative balance sheet effects has important implications for economic policy, the design of adequate regulatory frameworks to deal with dollarization risks, and the debate on the optimal exchange rate regime.”

The database is a new resource for conducting research on corporate finance, corporate governance and balance sheet effects in emerging markets. It includes accounting and other relevant firm-specific information covering the period 1990 to 2002 for more than 2,000 non-financial firms in 10 Latin American countries: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, Uruguay and Venezuela.

* A new database on the currency composition and maturity structure of firms' balance sheets in Latin America, 1990-2002 by Herman Kamil, November 2004.