Corporate investment and the exchange rate: The financial channel

Focus

This paper asks how the exchange rate affects corporate investment. Acting via a "financial channel", movements in the exchange rate influence domestic financial conditions by strengthening or weakening the balance sheets of domestic borrowers and foreign lenders. These effects arise from currency mismatches on balance sheets, or more generally through risk premia as global investors adjust their portfolios. Through this financial channel, a weakening of the exchange rate would be associated with a tightening of financial conditions, dampening economic activity. This contrasts with the traditional trade channel, where a fall in the exchange rate tends to have expansionary economic effects.

Contribution

We first propose a simple theoretical model to analyse different mechanisms through which the exchange rate might impact credit supply and hence investment. We then assess empirically the financial channel of the exchange rate using firm-level data for a group of advanced and emerging market economies (EMEs). To identify the financial channel of the exchange rate on investment, we use the cross-sectional variation in firm leverage and FX debt.

Findings

We find that the exchange rate affects corporate investment through a financial channel: a fall in the exchange rate dampens corporate investment, acting via firm leverage and FX debt. The effect is more pronounced in EMEs, reflecting their greater dependence on foreign funding and less developed financial systems. Moreover, we find that exchange rate depreciation induces debt-laden firms to increase their cash holdings. This also supports, from a different angle, the notion that the exchange rate also operates as a financial channel. Overall, these findings suggest that the large depreciation of EME currencies since 2011 amplified the recent slowdown of investment in these economies.

Abstract

Using firm-level data for 18 major global economies, we find that the exchange rate affects corporate investment through a financial channel: exchange rate depreciation dampens corporate investment through firm leverage and FX debt. These findings are consistent with the predictions of a stylised model of credit risk in which exchange rates can affect investment through FX debt or borrowing in local currency from foreign lenders. Empirically, the channel is more pronounced in emerging market economies (EMEs), reflecting their greater dependence on foreign funding and their less developed financial systems. Moreover, we find that exchange rate depreciation induces highly leveraged firms to increase their cash holdings, supporting from a different angle the notion of a financial channel of the exchange rate. Overall, these findings suggest that the large depreciation of EME currencies since 2011 was probably a significant amplifying factor in the recent investment slowdown in these economies.

JEL codes: E22, F31, F41, O16

Keywords: corporate investment, emerging markets, exchange rates, financial channel, financial constraints