Operational currency mismatch and firm level performance: evidence from India

Abstract

This paper looks at the determinants and effects of exchange rate exposure using data on 500 Indian firms over the period 1995–2011. Unlike the existing papers in the literature, we use a measure of ‘operational’ currency exposure based on foreign currency revenues and costs of firms. Among other factors, exchange rate volatility appears as a significant determinant of average firm-level exposure with the direction of relationship supporting the presence of ‘Moral Hazard’ in the firm’s risk-taking behaviour. Further, large ‘operational’ exposure is associated with significantly lower output growth, profitability and capital expenditure during episodes of large currency depreciation at the firm level. Together, these indicate that the policy-makers must take into account the incentive effects of their intervention in foreign exchange markets.

Keywords:

• operational currency exposure
• moral hazard
• exchange rate volatility

JEL classification:

• F1
• F4

Notes

^1. Unpublished manuscript available at http://finance.wharton.upenn.edu/weiss/wpapers/2000/00-3.pdf.

^2. Details of this measure are presented in the next section.

^3. Exchange rate is defined as domestic currency (Rupee) per unit of foreign currency.

^4. Estimates of country-level currency mismatch are based on two main, straightforward measures. The first is the ratio of net national debt or debt service requirements to the net exports of a country. The second is the ratio of foreign currency denominated liabilities to foreign currency denominated assets of the banking sector. Goldstein and Turner (2004) and Eichengreen et al. (2007) provide a review of the first strand of this literature, while Lane and Ferretti (2007) and Ranciere et al. (2010) are the latest example of the second strand.

^5. For example, imports comprised about 40% of the total cost in the aluminium industry while its share of foreign exchange earnings was only 30% of its total income in 2011. Air transport services, on the other hand, had 1.5% of its total costs going towards imports even though its share of foreign income in the total income was 18.5%.

^6. Hausman’s specification test between random and fixed effects estimator selected the former hence we used it for estimating Equation (1) Hausman’s Specification test: Chi sq (4) = 21.6, p = 0.00.

^7. The cut-off of 90% represents the 95th percentile of firms in terms of their export share. Similarly, the cut-off of 25% represents the 95th percentile of firms in terms of their import intensity (imports/income).

^8. Fisher’s Unit Root Test allows us to reject the null hypothesis of a unit root for all the variables (including output growth) in our model.

^9. The reason for using nominal Rupee–USD exchange rate for defining depreciation episodes is that Indian Rupee has been de-facto pegged to USD (see Shah and Patnaik (2010)).

^10. The cut-off value of 2.5 represents the top 2.5 percentile of the distribution of . Using alternative values of this cut-off does not change our results significantly.

^11. It is quite possible that large negative and positive exposure elasticities have a different impact on firm-level performance. We therefore repeat our analysis with separate dummies for large negative and positive exposures. However, the Wald test for coefficient restrictions showed that the coefficients on them were not significantly different from each other. We therefore continue with our original specification.

^12. We tested for the presence of unit roots in all our series using Fisher’s panel unit root test and were able to reject the null of unit root for all of them.

^13. We test for the presence of unit root in the series for capital expenditure using Fisher’s panel unit root test and are able to reject the null hypothesis of unit root. However, the test does point towards persistence in the series in the form of a lagged dependent variable.

Additional information

Notes on contributors

Anubha Dhasmana

Dr. Anubha Dhasmana has been working as an Assistant Professor at the Indian Institute of Management, Bangalore since September 2008. She currently teaches post-graduate and FPM students at IIM Bangalore. She did her doctoral studies in Economics from Johns Hopkins University, Baltimore, USA. She has received several awards and honors, including Department Fellowship, 2001–2006, Dept. of Economics, Johns Hopkins University; Hira Lal Bhargava Gold Medal, 2000, University of Delhi; Shri Ras Bihari Rohtangi Gold Medal, 2001, University of Delhi. She worked with the International Monetary Fund, Washington, DC during 2007–08, and has done assignments with the Los Angeles Times newspaper. Her research and teaching interests are in international macroeconomics and finance. She published the book External Capital Flows and Welfare in Developing Countries: Theory and Empirics (Saarbrucken, Germany: VDM Verlag Dr. Muller Aktiengesellschaft & Co. KG, 2009) and has written several academic articles in the area of capital flows, foreign reserve adequacy and welfare in developing and emerging market countries.