There is ample evidence of large real exchange rate depreciations that are accompanied by GDP contractions, at least in the short-run. Such behavior has been observed in several countries during the last 20 years (see Table 1 for some examples). The literature on liability dollarization and currency mismatch (Cespedes et al., 2004, Choi and Cook, 2004, Magud, 2010, Ize and Levy-Yeyati, 2005, Batini et al., 2007, Bleakley and Cowan, 2008 and Carranza et al., 2009) has suggested that a balance-sheet effect induced by exchange rate depreciations could be an explanation for this negative impact: when firms’ liabilities are denominated in a foreign currency, a depreciation may lead to a reduction in firms’ net worth which, in the presence of financial constraints, reduces access to credit and investment and, consequently, generates a contractionary effect that goes counter the traditional competitiveness effect of the depreciation. This effect is amplified when maturity mismatches exist, triggering also, in most cases, credit crunch episodes.
Table 1.
GDP Growth and Large Exchange Rate Swings.
Country Year Exchange Rate Depreciationa Domestic inflationb GDP Growth ratec
Argentina 2002 206 25.87 −10.90
Brazil 1999 56 4.86 0.25
Mexico 1995 90 35.00 −6.22
Nicaragua 1991 2930 116.60 −0.20
Paraguay 2002 39 10.51 0.00
Peru 1999 15 3.52 0.91
Dominican Republic 2003 66 27.45 −0.30
Russia 1998 67 27.68 −5.35
Thailand 1998 32 8.08 −10.50
Venezuela 2002 60 22.43 −8.90
Note: a,b,cin percentages.
Source: World Banka, IMFb,c.
Table options
Recent empirical analyses, however, have found only weak evidence for this effect (see Luengnaruemitchai, 2003, for a review), and usually only in the context of quite large depreciations (see, among others, Burstein et al., 2005; the papers in Galindo et al., 2003 and Leiderman et al., 2006). These empirical findings suggest that the aggregate investment function may present a nonlinearity in its dependence on the (real) exchange rate:
equation(1)
ΔIt=H(zt)+(λ+ρDt)Δet;Dt=1[Δet>φ]
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where ΔIt is the change in aggregate investment, H(zt) contains the effect of relevant variables other than the real exchange rate, Δet is the change in the real exchange rate, λ is the sensitivity of investment to “regular” real depreciations and ρ is the additional impact of a real depreciation that is “large” (i.e. greater than some threshold φ). Finally, 1[Δet>φ] is an indicator function that takes value one if the change in the real exchange rate is larger than φ.
In Eq. (1), the coefficient λ may be positive or negative, since it is a combination of a positive competitiveness effect (a real depreciation increases the output of firms that sell tradeables), of an increased relative cost of imported capital (a financial cost effect) and of a negative impact of the increase in relative worth of foreign currency liabilities (the balance-sheet effect). In this paper we argue, however, that the coefficient ρ is negative. We show in Section 2 how a simple financial friction may lead to an investment function of the form shown in (1), a result which explains the difficulty of finding robust empirical evidence for the balance-sheet effect of real depreciations. We then review in Section 3 some of the recent empirical literature on balance-sheet effects and the relationship between investment and real depreciations and show the results of an empirical analysis which support the possible nonlinear relationship between investment and the real exchange rate.
We have shown that in a small open economy with currency mismatch (liability dollarization) the
presence of a simple financial friction not only generates the traditional balance-sheet of a real
depreciation, but also a possible “large depreciation” effect. This effect may lead to a kink in the
investment/real exchange rate function so that it becomes downward sloping or, at least, its positive
slope is significantly reduced when the real depreciation is large. Contractionary balance-sheet effects
could, therefore, be empirically noteworthy only in the presence of large enough depreciations.
Furthermore, these effects should be more noticeable in countries that are highly indebted, that have
poorly developed financial markets, low proportion of tradeables in the composition of output or high
proportion of imported capital, and that show a high level of currency mismatch in firms’ liabilities.
Our results are, therefore, quite relevant in order to extend the empirical literature on the effects of
depreciations for emerging markets, which tend to be open countries with both high degrees of dollarization
and large exchange rate swings (Bigio and Salas, 2006; Leiderman et al., 2006; Ca’Zorzi et al.,
2007). We have presented new empirical evidence supportive of the model’s conclusions, although
more empirical work is needed in order to understand, especially, the implications of institutional
factors such as the development of the financial system or the impact of the extent of the currency
mismatch and the availability of hedging instruments. We believe, in any case, that our emphasis on
the necessary large size of the real depreciation may help uncover the, so far, quite elusive balancesheet
effects.
