Signaling with debt currency choice

BIS Working Papers  |  No 1067  | 
23 January 2023



Many emerging market firms finance themselves with foreign currency debt. Yet foreign currencies, especially safe haven ones, appreciate against the local currency during downturns. This has been a recurring theme in emerging market crises. Corporate leverage and foreign currency borrowing, especially in US dollars, have increased in recent years, making the reasons for borrowing in foreign currency and associated risks important to understand.


While there is a large literature on how foreign currency debt contributes to financial crises, analysing micro-level trade-offs that firms face and the resulting cross-sectional allocations provides a promising new avenue for research. Our paper makes a contribution to this nascent literature. In particular, we show that in the presence of information asymmetries, currency mismatches on balance sheets act as a signalling device. Firms take on exchange rate risks to signal their earning potential to investors. Signalling allows better firms to differentiate themselves from others, but it is costly. Our results suggest that policies that aim at reducing information asymmetries would mitigate corporate risk-taking through currency mismatches.


We first document that corporates for which borrowing in local currency would provide greater hedging benefits actually borrow more in foreign currency. We also document that firms tend to issue more debt in foreign currencies when the local currency cash flow volatility is greater. Guided by these facts, we build a model and show that there is a unique separating equilibrium in which good firms optimally expose themselves to currency risk to signal their type. Crucially, the nature of this equilibrium depends on the co-movement between cash flows and the exchange rate. Using a granular data set including more than 4,800 firms in 19 emerging market economies between 2005 and 2021, we show that foreign currency share indeed has signalling value as it predicts earnings.


We document that firms in emerging markets borrow more in foreign currency when the local currency actually provides a better hedge in downturns. Motivated by this fact, we develop an international corporate finance model in which firms facing adverse selection choose the foreign currency share of their debt. In the unique separating equilibrium, good firms optimally expose themselves to currency risk to signal their type. Crucially, the nature of this equilibrium depends on the co-movement between cash flows and the exchange rate. We provide extensive empirical evidence for this signaling channel using a granular dataset including more than 4,800 firms in 19 emerging markets between 2005 and 2021. Our results have implications for evaluating and mitigating risks arising from currency mismatches in corporate balance sheets.

JEL classification: D82, F34, G01, G15, G32

Keywords: foreign currency debt, corporate debt, signaling, exchange rates