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We estimate the exposure of emerging market companies to fluctuations in their domestic exchange rates. We use an instrumental-variable approach that identifies the total exposure of a company to exchange rate movements, yet abstracts from the influence of confounding macroeconomic shocks. In the sub-period of 1999–2002, we find that depreciations tend to have a negative impact on emerging market stock returns. In the sub-period of 2002–2006, this tendency has largely disappeared. Since we estimate the exchange rate exposure of firms from different countries with a common set of instruments, we can make coherent, cross-country comparisons of their determinants. We find that the impact of various measures of debt on exchange rate exposure, which is negative and significant in the early sub-period, becomes insignificant and even reverses sign in the recent sub-period.

In this paper we estimate the impact of domestic exchange rate movements on the stock market valuations of firms in emerging markets. We are interested in examining exchange rate exposure across different countries as well as the distribution of exposure within countries. We find that emerging market exchange rate exposure has changed within the last few years. In the immediate aftermath of the emerging market crises of the late 1990s (from 1999 to 2002), the share values of most emerging markets firms were negatively affected by exchange rate depreciations. In the more recent years (2002–2006), we find that this negative exposure has disappeared. Previous studies on developed markets typically focus on measuring marginal exchange rate exposure – the impact of an exchange rate depreciation on a firm’s stock return, controlling for the return on the national stock index. The inclusion of the national stock index is to control for the confounding effects of macroeconomic shocks, which can lead to simultaneous movements in the local currency and a firm’s stock price. This measure is typically used to assess the exchange rate exposure of certain interesting classes of firms (such as multinationals or exporters) relative to the national average. Yet, for emerging market firms, there are important reasons for us to focus instead on how they are affected by exchange rate fluctuations in absolute terms. First, from a macroeconomic perspective, we are interested in assessing whether emerging market firms as a class are negatively affected by exchange rate devaluations, not just how they perform relative to their respective country averages. Second, Morck et al. (2000) documented that the within-country correlation of stock prices is substantially higher for emerging than for developed markets. Such strong intra-national co-movements suggest that there are likely to be important country-specific components in exchange rate exposures. Using measures of total exposure, we can identify any such country-level, macroeconomic determinants of exchange rate exposures; with only measures of marginal exposure, any country-specific effects are already subtracted out and thus unidentifiable. To measure exposure at the national level, we need to distinguish between the direct effects of exchange rate movements on firm value, and the effects of other macroeconomic shocks that simultaneously affect both firm value and exchange rates. Because of the small size of any individual emerging market, its impact on the global financial market is limited. For this reason, we can treat world financial variables as exogenous to the emerging markets’ macroeconomic conditions. Specifically, we use variables such as the US Fed Funds rate, and the yen–dollar and euro–dollar cross-rates as instruments to identify the direct effects of exchange rate movements on firm value. Because we identify the exchange rate exposure for all firms using a common set of instruments, we can make coherent comparisons of the exchange rate exposure of firms in different countries. In a sample of 900 emerging market firms examined over the period 1999 through 2006, we find that the response of stock prices to exchange rate depreciations is mostly negative. On average, a 1% depreciation in the exchange rate is associated with a 0.4% decrease in stock price. There are about twice as many firms that have statistically significant and negative exposure as would be expected if there was no relationship between exchange rates and stock prices. However, these results for the full sample mask the changes in exchange rate exposure that have been occurring over time. Between 1999 and 2002, immediately following the various emerging market crises of the 1990s, we find that a 1% depreciation is associated with a 0.9% decrease in stock price, and about three times as many firms had significantly negative exposure as one would expect from a random sample. This finding is consistent with the phenomenon that numerous authors refer to as “liability dollarization”.2 By contrast, between 2002 and 2006, we find little evidence of negative exposure. On average, a 1% depreciation is associated with a 0.1% increase in stock prices. Further, there no longer seems to be a negative relationship between exchange rate exposure and debt (international or otherwise) at the firm or national level. In fact, in this recent sub-period, we find that depreciations are more likely to lead to increases in firm value in countries with substantial foreign debt. As we argue below, this finding is consistent with there being a greater dependence of emerging market firms on their domestic bond markets, and more opportunities for hedging through better-developed derivatives markets. The paper is organized as follows. Section 2 briefly reviews the current literature. Section 3 estimates the total exchange rate exposure using an instrumental-variable approach. Section 4 investigates the determinants of exposure. Section 5 concludes.

In this paper, we use an instrumental-variable technique to identify the total exposure of emerging market equities to exchange rate changes. This total exposure includes both the exchange rate exposure at the national level and the firm-level differences within a country. Using this instrumental-variable approach, we detect changes in the exchange rate exposure of emerging market stock returns over time. In the early sub-period of January 1999–June 2002, immediately following the emerging market currency crises of the 1990s, emerging market firms are mostly negatively exposed to exchange rate changes. In the recent sub-period of July 2002–June 2006, this negative exposure disappears. The traditional approach of estimating marginal exposure (by controlling for the national stock market return) would not be able to discover this broad, market-wide change over time. We go on to investigate the country-level and firm-level determinants of exposure. We find that in the early sub-period, there is a negative relationship between a company’s exchange rate exposure and (1) its level of international, foreign-currency debt; (2) its level of total debt; and (3) the level of external debt of the country in which the company is located. By contrast, in the recent sub-period, the relationship between debt and negative exchange rate exposure, at both the firm and country level, disappears and even reverses sign. The standard methodology used by previous studies would not have revealed the changing role of national debt levels in determining exchange rate exposure. This decline in negative exchange rate exposure coincides with a changing structure in many emerging markets’ debt. Eichengreen et al. (2006) outlined some of the structural changes being made in the East Asian and Latin American bond markets. In many countries, we observe very rapid growth in the market for domestic securities. McCauley and Jiang (2004) reported that, since the Asian crisis, Asia’s local currency bond markets have grown larger than its foreign-currency counterpart. At the same time, as documented by Jeanneau and Tovar (2006), there is a rapid growth in the Latin American domestic debt markets, which also exhibit lengthened maturity and a lower prevalence of currency- and inflation-indexed debt.10Table 6 presents the ratio of outstanding foreign-currency bonds to domestic-currency bonds for all countries in our sample (except Morocco), in the first quarter of 1999 and in the second quarter of 2006. In 9 out of the 14 countries, there is a noticeable decline in the size of the international bond market relative to the domestic bond market. Only in three countries is there a substantial increase in the relative size of the foreign bond market. More broadly, data from the Bank for International Settlements (BIS) show that, in June 2002, the notional value of OTC exchange rate derivatives in currencies outside the top 13 largest currencies was equivalent to 2.2 trillion. By June 2006, this sum had increased to 6.7 trillion. Over the same period, interest-rate securities in currencies outside the top 12 currencies increased from 2.3 trillion US dollars to more than 8 trillion. Although we cannot break down this data further by currency, the rapid growth in derivatives markets may have increased the opportunities for emerging market firms to hedge their exchange rate risks.