Capital Controls and Risk Misallocation: Evidence from a Natural Experiment L ORENA K ELLER a November 2018 [Click here for latest version] Foreign currency debt has led to many crises in emerging markets. However, in the past decade, firms in emerging economies have drastically increased their foreign currency borrowing, making them significantly exposed to depreciation shocks. To reduce their exposure to external shocks, central banks have increased their use of capital controls. In this paper I study whether capital controls can have the unintended consequence of inducing firms to borrow more in foreign currency.
I exploit heterogeneity in the strictness of capital controls across Peruvian banks to provide novel causal evidence of the effect of capital controls on local firms’ dollar borrowing from banks. Using a unique dataset that includes all foreign exchange transactions and loans given by Peruvian banks, I find that capital controls encourage firms to take more foreign currency loans. I describe a new mechanism to explain these findings, in which capital controls induce local banks to shift exchange rate exposure away from foreigners and onto domestic firms. This is worrisome as the literature shows that depreciation shocks have led to significant reductions in investment and employment for these firms.
Key words: capital controls, macroprudential policies, emerging markets, carry trade, corporate debt, currency risk, bank regulation, bank lending JEL: E44, F31, F32, F41, G15, G32 a Kellogg School of Management, Northwestern University. E-mail: l-kellerbustamante@northwestern.I have also greatly benefited from conversations with Laura Alfaro, Luigi Bocola, Anthony DeFusco, Martin Eichenbaum, Jay Khan, Guido Lorenzoni, Erik Loualiche, Dimitris Papanikolaou, Ricardo Pique, Sergio Rebelo, Hélène Rey and Sridhar Srinivasan. I am also thankful to the participants at EMCON 2017, Midwest Macro Meetings 2017, MFA 2018, SED 2018, TADC 2018, USC Marshall PhD Conference in Finance 2018, WFA 2018 and bag lunches at Northwestern Economics, Kellogg Finance and Fuqua Finance Bag Lunch for helpful comments and suggestions. I am indebted to the Peruvian Superintendencia de Banca y Seguros (Peruvian bank regulator - SBS) and the Superintendencia Nacional de Administración Tributaria (Office of income tax collection - SUNAT) for their collaboration in providing and collecting the data.
Conversations with the Peruvian Central Bank, with risk management and traders at Deutsche Bank (Peru and NY), Santander NY, Scotiabank Peru and Profuturo AFP have been very useful for my analysis. I am very grateful to Olivia Healy, Emily Hittner, Danielle Perszyk and Ruxue Shao for editorial help in preparing the manuscript. All errors are, of course, my own. Electronic copy available at: https://ssrn.
Introduction Numerous serious crises in emerging economies can traced back to the presence of large shares of govern- ment, corporate and bank debt denominated in US dollars (Chang and Velasco (1998), Krugman (1999)). This is worrisome because during the past decade, firms outside the US have quadrupled their US dollar debt. For instance, dollar denominated debt for firms outside the US has reached 9.8 trillion dollars, of which more than 30% is held by firms in emerging markets alone (McCauley et al.1 The currency mismatch caused by having debt in dollars but revenues in local currency severely exposes firms to depreciation shocks of the local currency. In essence, when the local currency depreciates, revenues in local currency lose value relative to the value of their dollar debt.
Various studies have found that the damage caused to the financial capacity of these firms after a depreciation shock has led to significant reductions in profits, investment and employment.2 Then, how can countries protect their economies from depreciation shocks that could erode firms’ balance sheets? An important source of depreciation shocks are sudden reversals of capital flows. Then, to prevent sudden outflows, economists widely recommend the use capital controls on inflows. 3 As a result, there is an increasing number of countries using capital controls on inflows to smooth flows across time. However, despite the concern about dollarization of firms’ debt and the wide use of capital controls, very little consideration has been given to the effect of capital controls on foreign currency borrowing of firms.
Then implicitely it is assumed that capital controls do not affect firms’ dollar borrowing. In this paper, I show this is not the case. To the best of my knowledge, this is the first paper showing that capital controls on inflows increase dollarization of firms’ debt. I describe a novel channel through which capital controls induce firms to take dollar debt and exploit the implementation of capital controls in Peru as a natural experiment to provide causal evidence of the effect of capital controls on dollarization of firms’ debt.
1 There are two reasons for the large share of dollar denominated debt for firms. First, particularly in emerging markets, domestic banks have more than 20% of their deposits in dollars (Catão and Terrones, 2016a) as households save partially in dollars to hedge against inflation. Then, the most important source of the dollar funding for firms has been domestic banks (McCauley et al. Second, the low dollar rates that followed the financial crisis, induced firms to substitute borrowing in local currency for borrowing in dollars (Bruno and Shin, 2015).
2 See Carranza et al. (2003), Echeverry et al. (2003), Pratap et al. (2003), Aguiar (2005), Cowan et al.
(2005), Gilchrist and Sim (2007), Hardy (2018) 3 See Mendoza (2010), Ostry et al. Many countries followed this advice, including Brazil, Indonesia, Peru, South Korea and Thailand. One example of this consensus is that, in fact, even the International Monetary Fund (IMF) changed its stance on capital controls and as of 2012, has supported their imposition. For more examples, see the letter that more than 200 economists sent to US Officials asking them to remove penalties to countries setting capital controls in trade agreements.edu/gdae/policy_research/CapCtrlsLetter.
pdf 2 Electronic copy available at: https://ssrn.com/abstract=3099680 The channel through which capital controls increase dollarization of firms’ debt relies on the following observation: Banks in emerging economies have a fundamental risk management problem. While domestic households want to save partially in dollars to hedge against inflation (Catão and Terrones, 2016a), firms that want to match the currency denomination of their revenues prefer to borrow in domestic currency. As banks intermediate between firms and households, banks are therefore naturally exposed to exchange rate risk. As a result, banks might decide to hedge this risk either by choice or by regulation4.
When capital controls are absent, banks can hedge this currency risk with foreign investors by taking positions in the currency forward market. However, an unintended consequence of capital controls is that banks can no longer hedge with foreign investors. As banks need to match the two sides of the balance sheet, banks could respond to capital controls by lending more in dollars and less in domestic currency.5 Peru offers a great laboratory to test whether banks respond to capital controls by lending more in dollars and lending less in domestic currency. In the aftermath of the 2008 financial crisis, Peru, as many other developing countries, imposed capital controls to cope with short term capital inflows.
These inflows aimed at earning the interest rate differential between Peru’s currency, soles, and dollars (a strategy named carry trade). Because foreign investors can engage in carry trade by either buying domestic short term bonds or by acquiring forward securities, for capital controls on carry trade inflows to work, they must block both channels. Following this rationale, capital controls in Peru consisted of (1) preventing foreign investors from buying short term securities and (2) setting limits on holdings of forward contracts.6 The way the limits on forward contracts were implemented provides identification strategy for my empirical work. Because foreign investors took forward positions against local banks, limits were imposed on local banks’ forward holdings.
Given that each bank had a different percentage utilization of this limit at the time these caps were announced, capital controls were not binding for all banks. Only a fraction of banks were forced to reduce their forward holdings because their holding positions were above the cap. The rest were not affected by the cap and could even increase their forward holdings. I use the banks above the cap as treated banks and the rest as the control group.
Exploiting the variation in the use of forward limits across banks, I identify the effect of capital controls on banks’ lending pattern of soles and dollars. I use 4 After the Asian crisis, bank regulators usually require banks to hedge exchange rate risk (Canta et al., 2006) 5 In partially dollarized economies, there is a stock of dollars in the economy, in addition to capital flows, that needs to be hedged. When banks can always hedge their foreign currency liabilities by buying dollars in the forward market, there is no reason for domestic banks to be more sensitive to sudden stops and exchange rate movements as banks can hedge both the flow and the stock of dollars. Therefore, there would be no need for banks to transfer the exchange rate risk to firms given that the exchange rate exposure of banks would already be hedged.
Although closing capital markets can also reduce dollar inflows, the economy still has a stock of dollars that needs to be hedged. 6 Examples of countries that set restrictions on the currencies forward market are Brazil, Colombia and Korea. Malaysia also did so in 1994. Between 2006-2008, Thailand set reserve requirements on currencies sold against baht.
3 Electronic copy available at: https://ssrn.com/abstract=3099680 difference-in-differences to compare differences in treated banks’ lending to that of banks in the control group before and after the implementation of forward limits. To isolate local banks’ credit supply from firms’ credit demand, I compare how the two groups of banks change lending to the same firm. My identification strategy rests on the credibility of the following three assumptions. First, banks should not anticipate the imposition of capital controls.
I verify this assumption by showing that banks’ strategies before capital controls announcement were opposite from those they would have followed if they knew capital controls were going to be imposed. Hence, it seems banks did not know capital controls were going to be announced.7 Second, banks in the control group should be a valid counterfactual for those in the treatment group. That is, the lending growth rate of treated banks would have been the same as that of banks in the control group if capital controls had not been imposed (parallel trend assumption holds). Although this condition is untestable, I perform various checks that suggest this condition is valid.
These checks include testing balance on observables and pre-trends as well as exploring possible explanations for pre-existing dispersion of forward holdings. Third, capital controls should be exogenous to prevent that my results capture the factors leading to the imposition of capital controls rather than to capital controls themselves. Although capital controls in Peru were an endogenous response to carry trade inflows, my identification strategy is still valid as long as the underlying factors that led Peru to set capital controls affect all banks and firms in the same way. To implement my identification strategy, I rely on unique, confidential data provided by the Peruvian bank regulator (the Superintendence of Banks and Insurance Companies - SBS).
My dataset includes the universe of forward contracts of all Peruvian banks, which I use to compute forward holdings and determine whether a bank is in the treated or control group. To determine the effects on bank lending, the Peruvian bank regulator also provided me loan level data of all commercial lending activities of banks. Hence, I observe all loans banks lend to firms across time. Using this dataset, I find that treated banks lent 10% more in dollars and 20% less in soles in the year following capital controls.
These changes in loans had long lasting effects in the balance of soles and dollar loans (more than 2 years).