Exchange Rate Exposure and Firm Dynamics

This paper develops a firm-dynamics model with heterogenous firms and endogenous currency debt composition to jointly study financing and investment decisions in developing economies. In our model, foreign currency borrowing arises from a trade-off between aggregate deviations from the risk-free uncovered interest rate parity and firms’ growth potential. Crucially, there is crosssectional heterogeneity in foreign currency borrowing decisions in two dimensions. First, there is selection into foreign currency borrowing, as only productive firms find it optimal to be exposed to exchange rate shocks. Second, among productive firms, those with low capital employ this financing more intensively, as it allows them to reach faster their optimal scale of production. We test the model’s implications using firm-level census data on firms’ balance sheets and debt by currency denomination in Hungary. Our empirical results confirm that high productive firms have a higher probability and share of foreign currency loans, and see higher investment and growth after using this financing. Additionally, we show that higher deviations from the risk-free uncovered interest rare parity associate with increases in foreign currency borrowing and investment, particularly of productive firms with low capital. Our quantitative framework shows that foreign currency borrowing associates with a ten percent higher aggregate income, but at the expense of higher volatility.