Abstract: Borrowing in foreign currency has historically induced a large currency mismatch on emerging economies' balance sheets, leading to financial instability and economic crises. Nonetheless, emerging market sovereigns still borrow a substantial amount in foreign currency. In fact, in this paper, we find empirically that emerging market sovereigns borrow even more in foreign currency when exchange rate volatility is higher, precisely when it is riskier for them to do so. This paper builds a quantitative sovereign default model with a risk-averse sovereign and risk-averse international investors, where the optimal currency composition of external sovereign borrowing is the outcome of a risk-sharing problem between the borrower and lenders. Emerging economies choose to bear exchange rate risk and borrow in foreign currency because international investors charge a high exchange rate risk premium on emerging market local currency debt. Moreover, the required premium on local currency debt is higher when exchange rate volatility increases, further dissuading emerging economies from borrowing in local currency. The estimated model with high risk aversion of lenders quantitatively matches well the foreign exchange risk premium, the relative borrowing cost in local currency over foreign currency, and the currency composition of external public debt. The model also performs well quantitatively in accounting for positive comovements between the foreign currency share of external public debt and exchange rate volatility, and the relative borrowing cost in local currency over foreign currency and exchange rate volatility. A counterfactual exercise shows that exchange rate stabilization results in a welfare gain to the emerging market sovereign of 0.35% measured in consumption equivalents.

Presented at:  KU Leuven Summer Event 2022,  Asian Meeting of the Econometric Society in China 2022 (AMES), Yonsei University, Society for Economic Dynamics 2022 (SED), Korea-America Economic Association, Midwest Macro Fall 2022, University of Maryland

First Version: November 2021

Abstract: This paper helps unravel the long-standing equity home bias puzzle by building a model in which an agent infrequently adjusts her portfolio holdings of home and foreign equities. As real exchange rate returns are volatile, an investor who invests in foreign equities and holds on to her portfolio holdings for a long duration is likely to drift away from an optimal allocation. The agent, taking infrequent adjustment into account ex-ante, lowers her demand for foreign equities, generating home bias in equities. The introduction of the euro into various European countries and the enlargement of euro area in subsequent years provide a natural environment in which to validate the implications of the model. We empirically document that European countries experience lower equity home bias after adopting the euro as cross-border equity investment within the euro area entails no nominal exchange rate risk. When the levels of real exchange rate volatility are calibrated to match the average levels for European countries in the euro area and outside the euro area, the model can match the difference in levels of equity home bias between European countries experienced after the introduction of the euro.

Presented at:  North American Summer Meeting  2019 (NASMES 2019), Midwest Macro Fall 2019, Economics Graduate Student Conference 2019 in St.Louis (EGSC 2019),  Western Economic Association International 2021 (Virtual, WEAI 2021)

First version:  December 2018

Abstract:  The substantial increase in global corporate debt over the past decade has revived macro stability concerns of foreign currency liability in emerging countries. Due to data unavailability, there is a limited understanding of how the debt proceeds are used. We empirically study the use of proceeds from debt issuance in different currencies at different maturities using a firm-level dataset from Korea, which provides information on the currency denomination of both assets and liabilities of firms. First, we find strong evidence of firms' engagement in carry trades and precautionary saving when a firm issues short-term foreign currency (FC) debt; issuing short-term FC debt is associated with higher local currency and foreign currency liquid assets. We further show that the same increase in short-term FC liability without cash inflows is not associated with an increase in local currency liquid assets, supporting that it arises from what firms do with their FC cash inflows when issuing FC debt. Second, we find that local currency debt financing supports a corporate finance pecking order prediction: an increase in investment and a fall in liquid assets. Third, we find that motives of carry trade and precautionary saving are stronger when the interest rate differential and exchange rate volatility are high, respectively. Sectors that are financially dependent or export exposed amplify the response. 

Presented at:  Midwest Macro Fall 2022

First version:  November 2021  

Abstract: With Korean firm-level and aggregated industry-level data, we explore a balance sheet channel of corporate foreign currency borrowing through which an exchange rate shock passes through to domestic producer prices. We empirically and theoretically explore this negative balance sheet effect in the determination of the exchange rate pass-through to domestic prices. Exploiting a large devaluation episode in Korea in 1997, we document that a sector with higher foreign currency debt exposure prior to the crisis experienced a larger price increase. We study the transition path upon unexpected exchange rate depreciation by building a heterogeneous firm model with working capital and financial constraints. Upon unexpected depreciation, firms with high foreign currency debt exposure face tighter working capital and financial constraints, which reduces investment and liquid savings, increasing the costs of production and prices. The model matches qualitatively and quantitatively the observed marginal effect of the short-term foreign currency debt ratio on the sectoral price changes. The estimated model can explain around 52% of the variation in price changes across industries during the crisis. From firm-level simulations, we decompose the two distinct channels of exchange rate pass-through – the balance sheet channel and the imported input channel – at the firm-level. We show that firms increase their prices and reduce their markups as they have higher foreign currency debt exposure when they are financially constrained, consistent with the empirical relationships documented.

Presented at:  Midwest Macro Fall 2019, Korea International Economic Association 2022 Winter Conference at SNU, ASSA Meeting 2023, Ohio State University, Yonsei University (scheduled), University of Seoul (scheduled)

First version: August 2019