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Information Asymmetry and Foreign Currency Borrowing by Small Firms

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Abstract

We model how an information asymmetry between the lending bank and the applying firm about the currency structure of firm revenues may affect loan currency choice. Our framework features a trade-off between the lower cost of foreign currency debt and the costs of currency induced loan default. We show that under imperfect information about firm revenues more local earners choose foreign currency loans, as they do not bear the full cost of the corresponding credit risk. This result is consistent with recent evidence showing that information asymmetries may increase foreign currency borrowing by retail clients in the transition economies.

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Notes

  1. In East Asia, corporate debt is split about equally between foreign and domestic currencies (Allayannis et al., 2003) while in several Latin American countries the share of foreign currency debt exceeds 20% (Galindo et al., 2003). Between 20% and 75% of all corporate loans in Eastern European countries are denominated in a foreign currency (European Central Bank, 2006, p. 39).

  2. Foreign currency loans create serious challenges to policymakers. Countries with high volumes of foreign currency loans are more vulnerable to financial crises and more prone to spillover effects of country-specific shocks (see, eg, Cetorelli and Goldberg, 2011). Furthermore, foreign currency-denominated loans distort the transmission of monetary policy, influence the available credit in the economy, and therefore can impact the catching-up process of transition countries (see, eg, Gorodnichenko and Schnitzer, 2010).

  3. In contrast to these two studies, others have examined foreign currency borrowing by analyzing aggregate cross-country data (eg, Luca and Petrova, 2008; Rosenberg and Tirpák, 2009; Basso et al., 2011) or the currency denomination of debt of large firms within a single country (Keloharju and Niskanen, 2001; Benavente et al., 2003; Gelos, 2003; Kedia and Mozumdar, 2003; Cowan et al., 2005) or across countries (Rajan and Zingales, 1995; Booth et al., 2001; Allayannis et al., 2003; Cowan, 2006; Esho et al., 2007; Kamil and Sutton, 2008; and Kamil, 2009). Clark and Judge (2008) provide a review of the relevant empirical literature.

  4. We will not discuss: (1) International taxation issues such as tax loss carry forwards and limitations on foreign tax credits; (2) The possibilities for international income shifting; (3) The differential costs across countries of derivatives to create synthetic local debt; and (4) Clientele effects in issuing public bonds. These issues are clearly important when analyzing the debt structure of large corporations.

  5. See, for example, Dollar and Hallward-Driemeier, (2000). In addition, banks often cannot verify firm sales information through advanced cash management services, which are yet to be introduced there, either because banks do not offer these services (eg, Tsamenyi and Skliarova, 2005) or firms do not demand them (eg, in the survey analyzed in Brown et al., 2011, one-third of the firms report receiving less than one third of their income through their banks). Banks may also lack information on firm quality, project choice, or managerial effort, eg, incurring monitoring costs (Diamond, 1984; Diamond, 1991) or forming relationships with the firms (Sharpe, 1990; Rajan, 1992; von Thadden, 2004; Hauswald and Marquez, 2006; or Egli et al., 2006, among others). Also other financiers may face more information asymmetries in transition and developing countries (eg, Claessens et al., 2000).

  6. See Friberg and Wilander (2008). Firm risk aversion (Viaene and de Vries, 1992), currency variability (Engel, 2006), and medium of exchange considerations (Rey, 2001) may determine currency choice.

  7. If the firms’ cash flows are in foreign currency, borrowing in the same foreign currency will provide a straightforward natural hedge (Goswami and Shrikhande, 2001). Mian (1996), Bodnar et al. (1998), Allayannis and Ofek (2001), and Brown (2001), among others, analyze the hedging of foreign currency exposure, using forward contracts and derivatives for example. But many developing country currencies have no forward markets; and even in those that do, there are substantial costs to hedging (Frankel, 2004). And even in developed countries, small firms rarely use derivatives to hedge their net currency exposure (Briggs, 2004; Børsum and Ødegaard, 2005; and O’Connell, 2005, among others). As expected, therefore, small firms in developing countries not uncommonly default on loans in foreign currency following a deep depreciation of the local currency (Ziaul Hoque, 2003). Static capital structure trade-off theory suggests firms opt for the lowest cost debt, making the interest rate differential, that is, the deviations from the UIP, the second main determinant of the firm's choice of loan currency denomination (Graham and Harvey, 2001).

  8. As we later assume that the level of firm revenues does not change with the exchange rate, the changes in the exchange rate in our model are assumed to be real.

  9. For a richer model in which firms also differ with respect to their debt-to-income levels, see the SNB Working Paper version of our paper (Brown et al., 2009b).

  10. See Goldberg and Knetter (1997), for example, on exchange rate pass-through.

  11. Firms in our model receive both their expected income and their loan in a single, though not necessarily the same, currency. Without qualitatively affecting the main hypotheses, our model is readily extendable to include firms that receive their expected income and loans in varying proportions in multiple currencies.

  12. This is a crucial assumption in our model. If the UIP holds then the local currency earners will not have any incentive to borrow in foreign currency, as they will only bear higher costs either in terms of higher interest rate and/or in terms of prevailing distress costs.

  13. General reviews by Hodrick (1987), Froot and Thaler (1990), Lewis (1995), Engel (1996), for example. For emerging markets, see Francis et al. (2002) and Alper et al. (2009).

  14. Given our focus, we do not derive the optimality of this debt contract (see Townsend, 1979,eg).

  15. For example, this corresponds to the risk aversion of managers, as in Stulz (1984), or of firms, as in Calvo (2001).

  16. As financially distressed firm may lose customers, suppliers, and/or employees depending on the characteristics of their products and labor contracts for example, financial distress costs are also assumed to be heterogeneous across firms in Purnanandam (2008). Andrade and Kaplan (1998) estimate that financial distress costs vary between 10% and 20% of firm value (see also the review by Senbet and Seward, 1995). For small firms, both the level and dispersion of these costs are likely to be even higher (eg, Pindado et al., 2006).

  17. See the SNB Working Paper version of our paper (Brown et al., 2009b) for a model with a continuous distribution of firms’ distress costs. A discrete distribution makes the analysis more elegant, yet does not alter the main intuition that imperfect information leads to more foreign currency borrowing.

  18. In our model, all banks are equally affected by the information asymmetry regardless of the currency in which they lend. Most domestic and foreign banks in Eastern Europe, for example, offer loans in both local and foreign currency to local firms (see Brown et al., 2011 and Brown et al., 2012). If financiers lend only in their own currency, existing models predict that: (1) Firms may borrow first in the local and then in the foreign currency, after having exhausted internal funds, if local financiers have better information about the firm than foreign financiers (pecking order hypothesis); (2) Firms with high monitoring costs may borrow more locally in the local currency (Diamond, 1984); and (3) Better firms may borrow in the foreign currency to signal their quality, if foreign currency debt is more expensive (Jeanne, 1999) or entails more regulatory scrutiny hence higher distress costs (Ross, 1977).

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Acknowledgements

We thank an anonymous referee for Comparative Economic Studies and an anonymous referee for the Swiss National Bank Working Paper Series, Raphael Auer, Söhnke Bartram, Henrique Basso, Katalin Bodnar, Josef Brada (the editor), Geraldo Cerqueiro, Andreas Fischer, Davide Furceri, Luigi Guiso, Werner Hermann, Herman Kamil, Anton Korinek, Marcel Peter, Alexander Popov, Maria Rueda Mauer, Philip Sauré, Linus Siming, Clas Wihlborg and seminar participants at the University of Amsterdam, the Federal Reserve Bank of Boston, the University of Zurich, the Swiss National Bank, as well as participants at the European Finance Association Meeting (Bergen), the SNB-CEPR conference on ‘Foreign Currency Risk Taking by Financial Institutions, Firms and Households’ (Zürich), the Financial Intermediation Research Society Meeting (Prague), the CEPR/Studienzentrum Gerzensee European Summer Symposium in Financial Markets (Gerzensee), the European Economic Association Meetings (Milano), the CREDIT Conference (Venice), ESCE Meetings (Paris), the NBP-SNB Joint Seminar on ‘Challenges for Central Banks during the Current Global Crisis’ and the Tor Vergata Banking and Finance Conference (Rome) for useful comments and discussions. Ongena gratefully acknowledges the hospitality of the Swiss National Bank. Any views expressed are those of the authors and do not necessarily reflect those of the Swiss National Bank.

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Authors and Affiliations

  1. University of St Gallen, Rosenbergstrasse 52, St. Gallen, 9000, Switzerland

    Martin Brown

  2. CentER – Tilburg University and CEPR, PO Box 90153, LE Tilburg, 5000, Netherlands

    Steven Ongena

  3. Swiss National Bank, PO Box 2800, Zurich, 8022, Switzerland

    Pinar Yeşin

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Appendix

Appendix

Proposition 1:

  • Under perfect information, all F firms take foreign currency loans. The equilibrium share of L firms that choose foreign currency loans is given as:

Proof.

  • Recall that the equilibrium interest rates on loans under perfect information can be written as:

    Recall also that the expected payoff of firms can be written as:

    and that the expected depreciation of the local currency is assumed to be 0:

    Inserting the equilibrium interest rates from (A.2) into the expected payoff of firms (A.3), and using the equation (A.4), we obtain the following two results:

    1. 1

      Foreign currency earners (F types) will always choose foreign currency loans, because their expected payoff will be higher when they take a foreign currency loan than when they take a local currency loan. Thus, all F firms will take foreign currency loans.

    2. 2

      An L firm will choose a local currency loan when

    The condition (A.5) tells us when it will be preferable for a local currency earner to borrow in foreign currency based on the values of the distress costs, the probability of depreciation, and the interest rate gap. In other words, a local currency earner will choose to take a local currency loan if its expected cost of default on a foreign currency loan is larger than the interest rate on local currency loans.Recall that we assumed only two values for Thus if then all local currency earners will choose a foreign currency loan; and if then no local currency earner will choose a foreign currency loan. For intermediate values of i l , only local currency earners with low distress costs, , will choose a local currency loan. Thus, the equilibrium share of L firms that choose foreign currency loans can be written as:

    Note that (A.6) is equivalent to (A.1). 

Proposition 2 (Separating Equilibrium):

  • If then a separating equilibrium will emerge.

Proof.

  • In a separating equilibrium, all local currency earners will choose a local currency loan by definition. Thus, we have the share of L firms taking a foreign currency loan equal to 0, that is, δ=0. Recall that the equilibrium interest rate for foreign currency loans can be written as:

    Therefore, r f =0 when δ=0.Also recall that

    From (A.8) it follows that a separating equilibrium exists, if  

Proposition 3 (Partial Pooling Equilibrium):

  • If and a partial pooling equilibrium exists in which only L firms with low distress costs take foreign currency loans while L firms with high distress costs take local currency loans.

Proof.

  • In a partial pooling equilibrium, some local currency earners will choose a local currency loan, whereas others will choose a foreign currency loan. Recall that distress costs can take only two values, . Therefore, in a partial pooling equilibrium, the share of L firms that take a foreign currency loan should equal to the share of L firms that have low distress costs. Hence, δ=ϕ.Recall that the equilibrium interest rate for foreign currency loans can be written as in (A.7). Therefore,

    Substituting (A.9) into (A.8), it follows that only L firms with low distress costs will chose a foreign currency loan if:

    and

Proposition 4 (Full Pooling Equilibrium):

  • If a full pooling equilibrium exists in which all L firms take foreign currency loans.

Proof.

  • In a full-pooling equilibrium, all local currency earning firms take foreign currency loans, that is, δ=1. In this case, the expression (A.7) yields that the equilibrium interest rate for foreign currency loans is

    Substituting (A.10) into (A.8), it follows that a full-pooling equilibrium exists if  

Proposition 5 (Market Failure Imperfect Information):

  • Under imperfect information, there is no equilibrium in which foreign currency loans are extended if one of the following two conditions is met:

    or

Proof.

  • Follows directly from propositions 2, 3, and 4. 

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Brown, M., Ongena, S. & Yeşin, P. Information Asymmetry and Foreign Currency Borrowing by Small Firms. Comp Econ Stud 56, 110–131 (2014). https://doi.org/10.1057/ces.2013.9

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