Signaling with Debt Currency Choice

Abstract

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.

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

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