Exchange rate effects on firm performance: a NICER approach

Summary

Focus

This paper examines how exchange rate movements affect firms' financial health and real decisions such as investment and hiring. We focus on the "valuation effects" of exchange rate changes, which influence the values of exports and imports in local currency. This channel matters when most trade is invoiced in a few dominant currencies, such as the US dollar. In the short term with sticky prices, the valuation effects can outweigh the expenditure-switching effects on trade volumes.

Contribution

We study how exchange rate valuation effects influence firm profits, liquidity, credit, investment and employment, using Thai micro data. We present a simple model to highlight the valuation channel and distinguish it from other exchange rate channels. To measure the effects, we build a new exchange rate index, "NICER", which accounts for invoicing currency mismatches between imports and exports. We also explore how foreign exchange hedging can mitigate these effects. Our paper is the first to study valuation effects in an emerging market economy, and the first to examine liquidity and credit implications anywhere.

Findings

NICER movements significantly affect firms' profits. A NICER appreciation lowers exporters' profits, especially for smaller firms. NICER outperforms trade-weighted exchange rates in explaining firm profits. Valuation effects also affect liquidity and real decisions. Exporters face liquidity squeezes and cut investment and hiring as NICER appreciates. Only large exporters can raise short-term financing to cushion these cash flow shocks. Financial hedging, employed by some firms, only partly shields them from valuation effects.

Abstract

Under dominant currency pricing, exchange rate swings affect firms' profits in domestic currency rather than price competitiveness. We quantify these valuation effects by constructing firm-specific exchange rates that reflect invoicing currencies and capture cash-flow exposures. These net-invoice-currency-weighted exchange rates (NICER) outperform trade-weighted exchange rates in explaining firm profitability, particularly for smaller exporters. Higher trade dependency amplifies NICER sensitivities, while financial hedging only partially mitigates them. NICER fluctuations also impact firm liquidity and credit conditions, with large exporters offsetting liquidity shocks through external financing. These cash-flow effects, in turn, drive exporters' investment and employment decisions.

JEL classification: E44, F31, F41

Keywords: exchange rates, valuation effects, dominant currency paradigm, firm-level data, firm profitability, invoicing currency, exports, financial hedging