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RCC Paper Version Mar19 PDF
RCC Paper Version Mar19 PDF
Abstract
This study analyzes the effects of exchange rate fluctuations on corporate credit default in a dollarized
economy. The application of a new regulation on currency induced credit risk (CICR) in the Peruvian
banking system, and a posterior episode of exogenous exchange rate shock, created the condition of a
natural experiment to compare exposed and not-exposed corporate borrowers. This study uses two
definitions of currency exposition: debt dollarization and a self-reported indicator of CICR produced by
private banks as established by the new regulation. Contrary to literature using aggregated or bank-level
data of debt dollarization as a proxy for CICR, this study uses firm-level data to find that the effects of
CICR and debt-dollarization on credit risk are opposed. While CICR increases default, debt dollarization
reduces it. Our results suggest that banks transfer exchange risk as a hedging mechanism by lending in
dollars only to high quality borrowers. Consequently, debt-dollarization and CICR become disconnected.
1
The authors thank Enrique Mendoza, Christopher Cummings, Stephen Kay, Tapen Sinha, Myriam Quispe-Agnoli
and the people from the Federal Reserve Bank of Atlanta for their comments during the visit of one of the authors
to their Research Department. We are also grateful to Javier Poggi and Michel Canta from the Superintendencia
de Banca y Seguros del Peru for letting us use their database and for their support to this research.
1. Introduction
One major issue discussed in the literature on dollarization is the exposure of firms to exchange
rate volatilities due to currency mismatches (see for example, Ennis, 2000 and Broda & Levy-Yeyati,
2000). In a dollarized economy, banks face two options: to keep the currency risk and lend in local
currency, or to transfer the currency risk to firms by lending in dollars. In the former option, the bank is
transforming currency risk into credit risk. This risk transferred to firms is the Currency Induced Credit Risk
(CICR) which captures the impact of exchange rate fluctuations on firms’ credit default.
In dollarized economies2, transferring currency risk to firms will be an optimum hedge mechanism
only if the CICR is smaller than the currency risk held by the bank. That would be possible only if firms can
fully or partially hedge CICR, which means they have mechanisms to offset currency fluctuations. In
emerging economies, market mechanisms for hedging like futures, derivatives or swaps are very limited
and only available for big corporations, resulting in the use of self-hedging mechanisms to cover risks.
One of these mechanisms is currency matching that requires firms to generate income in dollars and
match their dollar liabilities to assets. Another mechanism is to keep enough reserves to cover for
unexpected income fluctuations, including currency volatility. This mechanism does not require currency
matching or dollar income generation for the firm, but only explicit or implicit reserves to hedge against
currency fluctuations.
Some attempts to measure the effect of currency fluctuations on CICR have considered
aggregate country data (Cayazzo, et al., 2006; Reinhart and Kaminsky, 1999; Gulde et al., 2004; De
Nicoló, et al., 2003; Magud, 2009) as well as firm-level data (Bleakley and Cowan, 2006 and Carranza,
Cayo and Galsón-Sanchez, 2003, Cowan et al., 2005, Galindo, et al., 2003). However, in all cases debt-
dollarization has been considered as proxy for CICR. The rationality for this approximation rests on the
assumption that CICR can only be hedged by currency mismatching when market mechanisms are
absent. Consequently, highly debt-dollarized firms are more likely to have currency mismatches.
Using aggregated country data, Cayazzo et al. (2006) studied dollarized vulnerabilities in small
economies using growth of nonperforming loan ratios and estimates of annual loan provisions. The study
2 Machicado (2008) shows how liquidity uncertainty may increase the degree of dollarization in the banking system.
determined that the impact of credit risk devaluation is higher in countries with higher dollarization.
According to the findings of Cayazzo, et al., the quantitative effect of a shock on exchange rate credit risk
varies substantially across countries with a threshold effect that depends on the degree of dollarization. In
particular, Cayazzo et al. articulated a supervisory framework that addressed partially dollarized banking
systems’ vulnerabilities, which loosely follows the Basel Committee for Banking Supervision (BCBS).3
Additionally, the effect of exchange rate fluctuations has also been discussed by Ize and Powell (2004)
who identified how partial dollarization increases the vulnerability of financial systems’ liquidity risks. Few
studies have used firm-level data to analyze the impact of currency fluctuations. Bleakley and Cowan
(2006) used micro data of firms for Argentina, Brazil, Colombia, Chile, México, Peru, and Venezuela from
1990 to 1999. They studied the firm’s mismatches between short and long term debt during financial crisis
episodes. Bleakley and Cowan found that capital flight that emerging countries bear during crisis did not
affect the structure of firm’s liabilities. This result contrasts a previous study by Carranza, Cayo and
Galsón-Sanchez (2003).4 Also, Serieux (2009) find in a Paraguayan sample of firms that partial
dollarization led to negative balance sheet effects, in the form of reduced access to investment credit due
to depreciation-induced reduction in firms’ net worth as a result of currency mismatches on their balance
sheets5.
Using firm’s debt-dollarization as a proxy for CICR imposes an important limitation in applied
studies. First, it omits other hedging mechanisms that firms may use to reduce CICR, mainly additional
reserves. Second, and most importantly, it could understate the real effect of currency fluctuations on
credit default by assuming that banks are naïve and passive. Banks can reduce overall risk by transfering
currency risk to the most solvent firms--those who have more reserves to hedge CICR. In that way, banks
will replace a high currency risk with a smaller CICR. This risk management strategy would have two
empirical consequences. First, the most solvent firms--which are not necessarily the currency matched
firms--will also be the most debt-dollarized. Second, currency fluctuations would do less harm to the most
3 The Basel Committee for Banking Supervision (BCBS) established a comprehensive framework for the oversight of
banking activities. This framework was revised in the context of Basel II and it specifies several recommendations to
align the capital measurement with sound and contemporary practices in banking and promotes further
improvements in risk management. The specific documents on the management and supervision of the main banking
risks, including credit market and liquidity risks are, in principle, applicable to all banking systems.
4
These authors concentrated their analysis on the Peruvian banking system.
5
Same result is obtained by Fuentes (2009) for a Chilean sample data of firms.
debt-dollarized firms. Consequently, debt-dollarization will not be a good proxy for CICR, and its use
The first contribution of our study is to overcome the limitations of using debt-dollarization as a
proxy for CICR. We take advantage of unique firm-level data from a dollarized emerging country that
includes separate estimates for debt-dollarization and CICR. CICR was internally estimated by banks
The second contribution of this study is that it estimates the impact of debt-dollarization and CICR
on credit risk separately in a period of an exogenous currency shock. The implementation of the CICR
regulation in a period of highly stabilized currency fluctuation, and a posterior temporal currency shock
originated by a political event, created the condition of a natural experiment to evaluate the impact of
exposed and not-exposed corporate borrowers on credit default, using debt-dollarization and self-
Our study shines more light on the discussion of financial dollarization and balance sheet effects
in dollarized economies. It also provides more information on how banks transfer and hedge currency risks
by lending in dollars to the most solvent firms. Debt-dollarization could be the result of an efficient risk
management strategy when markets for financial hedging products are underdeveloped. Consequently,
policies that put limits to debt-dollarization may produce more harm than benefits.
The paper is organized as follows: Section 2 describe the CICR regulation in Peru. Section 3
present the data and methodology performed. Section 4 shows the results and the last section concludes.
During the 1980´s, the Peruvian economy experienced hyperinflation. Large government
spending driven by populism and ambitious investment programs produced fiscal deficits and
unsustainable foreign debt. The government started to print money to accomplish their obligations with the
international financial markets, thus creating high rates of inflation. This induced a recomposition of
currency portfolios toward dollars (IMF, 2001). After Peru’s stabilization, the preference for foreign
currency is still high. The share of dollar debt from 2005 to 2006 was two thirds of total loans.
In 2005, Peru’s banking system regulator, the Superintendencia de Banca y Seguros (SBS),
issued the regulation SBS N°041-2005, which authorized the adoption of a surveillance monitoring
system to identify, measure, control and report accurately loan level exposure. The reports were required
to include evaluation of control mechanisms as well as the corrective actions or mandatory improvements.
At the same time, the legislation compelled the Director to implement policies and procedures to identify
The regulation establishes three different forms of CICR’s regulation: limit of exposure,
provisions, and capital requirement. If a bank does not identify its exposure then it is penalized with
additional provision. Exposed debtors can be identified by an assessment of their capacity to pay versus
flow of payment. Banks are allowed to use their own internal methodologies to identify debtors with CICR,
Regarding a debt’s qualification, banks should take corrective actions in case the CICR
affects the payment capacity of a firm. The regulator requires doing an annual stress test of the bank´s
liabilities.
3.1 Data
After a long period of low volatility in the exchange rate (see Figure 1), the nuevo sol plummeted
from 3.25 to 3.45 per dollar between August 2005 and mid January 2006, which represented a devaluation
of 6%. The electoral environment in Peru triggered the devaluation of the local currency when national
surveys reported that the leftist candidate, Ollanta Humala, placed second in the polls for the presidential
race. There was a financial turmoil in the Peruvian financial markets because of the possibility of having a
In spite of the significant devaluation of the Peruvian nuevo sol, it did not produce a currency
collapse in the financial system, and it is clear that this devaluation was caused by political expectations
rather than current macroeconomic conditions, implying that this was a truly exogenous shock
independent of credit conditions. Coincidentally, the CICR regulation passed in January 2005, eight
months before the dollar volatility. The law provided that banks should start reporting CICR indices in June
2005, 3 months before the devaluation, suggesting that the first reports were exogenous to the exchange
rate shock. This temporal exogenous shock in the exchange rate created the condition of a natural
experiment to test the role of CICR and debt-dollarization in the impact of exchange rate shocks on
[Insert Figure 1]
The data in the analysis include detailed debt information of 42,059 small and medium firms
during the period June 2005 – July 2006 (see Figure 1). The data was reported by the four biggest
Peruvian banks, which concentrate more than eighty percent of loans in the system and have the most
reliable internal methodologies for CICR. The information was obtained from the Credit Bureau
Our analysis search to examine the empirical relationship between the hazard rate and the factor
that induces the firms to default. Default was defined as a binary variable that equals 1 when the loan is
past due for more than 90 days. In order to investigate these factors, we applied a parametric duration
model where default is the event that defines the hazard. Similar strategies to estimate credit default have
been considered in the literature6. A parametric model was considered over a semi-parametric
specification after rejecting the hypothesis of proportionality of hazard function. Using a score test based
level.
3.2 Methodology
Let T denote a continuous non-negative random variable representing survival time, with
probability density function (pdf) f(t) and cumulative distribution function (cdf) F(t) = Pr{T ≤ t}. We focus on
the survival function S(t) = Pr{T > t}, the probability of being alive at t, and the hazard function (t) =
f(t)/S(t).
6
See for example Belloti and Crook (2007) who analyzed the macroeconomic determinants of credit card defaults
using a logistic duration model.
∫ t0 λ (u )du
Let (t) = denoted the integrated hazard and recall S(t) = exp{- (t)} (see Wooldridge,
2002). We assume “t” distributed as exponential. In an exponential distribution, we could let the
Where X is a vector of variables that may determine the variable λ . In our case λ is the time span until a
firm has a debt past due 90 days (default) and the X consider the variables presented in table 1.
For the estimation we considered the following variables listed in Table 1. Basic descriptive
Spells in our duration model were right censored. We selected firms that were not in default at
baseline, and we followed them for 14 months until July 2006, when 13.9% of firms defaulted in or before
July 2006 (completed spells), and 86.1% remained solvent (right censored spells).
[Insert Table 1]
We expected the variable CICR increased the probability of credit default during this period of
temporal shock in the exchange rate. If a firm has CICR then its probability of default should be higher
because it is more exposed to unexpected devaluation. For the firm’s debt dollarization, however, we
expect a negative relationship with default if our hypothesis that banks lend in dollars to the most solvent
firms is valid. A positive relationship would indicate that banks do not reduce total risk when they lend in
We control for observable firm’s characteristic. Because default is defined using the number of
past due days, we control by the delayed days in payment (DAYS), which is, by construction, less than 90
7
DEFAULT variable is the Time Span until a firm declares in credit default for firm I which is under assessment.
days. Firms with a higher delay in days should have a higher probability of default. We also include a
dummy variable for size of the firm (SIZE_SMALL), the number of banks where the firm holds debt
(BANKS), the ratio of collaterals to debt (COVERAGE), the ratio of non-performing loans to total debt
4. Results
We have considered four different estimations. Each specification is presented in Table 2. All
estimations reported robust standard errors, and a Variance Inflation Factor (VIF) test eliminated the
tried, without major impacts on our results. Although the semi-parametric Cox proportional hazard model
was ruled out after testing for proportionality, the results were also similar to the parametric counterpart.
[Insert Table 2]
The first model replicates the traditional approach of using dollarization as a proxy for CICR
without controlling for observable factors. The hazard ratio (HR=0.682) describes a negative and
statistically significant impact on probability of default. When CICR is included (model II), the hazard ratio
for dollarization remains significant at 1% but becomes even smaller (HR=0.669). On the other hand, the
hazard ratio for the CICR indicator is statistically significant, and it suggests a positive relationship
Adding controls to the regression (Models III and IV) reduces the impact of dollarization and
CICR, but both variables remain statistically significant. In the model with only dollarization (Model III), the
hazard ratio suggests a lower but still negative impact on default (HR=0.825). As before, adding the CICR
amplifies the impact of dollarization on probability of default (HR=0.808). In this model, CICR is still
significant, and, although its impact default is still positive, its magnitude is smaller than in the model
The impact of control variables reported in Models III and IV were as expected, with the
exceptions of firm’s size and coverage, which were not statistically significant. The number of banks where
the firm has loans was also statistically significant. The results show that the larger the number of banks,
the higher the probability of default, a relationship that deserves further exploration, but that is out of the
We estimate the impact of debt dollarization on credit default in a period of a temporal exogenous
shock in the exchange rate. Our results show that firms with a higher debt dollarization are 0.825 times
less likely to default than firms with lower debt dollarization. This result confirms our hypothesis that banks
lend in dollars to the most solvent firms as a mechanism to hedge currency risk. By selectively lending in
dollars, banks are efficiently transforming a certain level of currency risk into a lower level of CICR. This
result is similar to what Cowan et al. (2005) found for Chilean non-financial firms. The authors used a firm
level study to explore determinants and consequences of currency mismatches in Chile, finding that in
periods following a depreciation firms with higher dollar debt did not underperform their lower dollar debt
counterparts.
This result suggests that dollarization is not a good proxy for CICR, and that empirical papers that
rest on this assumption are over-estimating the real impact of CICR on creditworthiness. We can also see
this when we include the measure of CICR estimated internally by banks. When CICR is included in the
regressions, the negative impact of dollarization on default becomes even higher. Our paper benefits from
this unique measure of CICR, which proved to be consistent with the data. As expected, firms that are
exposed to CICR as reported by this measure are 1.067 more likely to default than non-exposed firms
during a devaluation period. Although the effect is small in magnitude after controlling for a firm’s
observable characteristics, this impact is statistically significant. Most importantly, the sample design used
in this study guarantees that the CICR indicator was exogenous to the exchange rate shock experienced
Our study sheds light that CICR and DOL have different effects on creditworthiness in periods of
exchange rate turbulence in a dollarized economy. Our results contrast with the standard claim in the
literature that dollar denominated debt poses excessive risk to financial institutions, and that firms with
high levels of debt dollarization cannot reduce currency risk, imposing an equal level of credit risk to
banks. Indeed, our results suggest that solvent firms have a cushion to assimilate part of the currency risk,
lowering the level of credit risk to banks. In this way, banks can partially hedge their own currency risk by
lending in dollars to the most solvent firms. This process creates a gap between debt dollarization and
CICR, making these two variables disconnected. Although our study supports this hypothesis, it is not
conclusive. Better firm level data is required to explore and understand this process.
control CICR in a highly dollarized developing country. Banks’ internal methodologies to identify CICR
were consistent in predicting a positive impact on default during a shock to the exchange rate. To our
knowledge, there is no other country that has implemented a similar mechanism to control the effect of
exchange rate volatilities on credit default. Most countries (Argentina and Chile, for example) use limits to
loans in foreign currency (US dollars), so rather than focusing on CICR, these regulations focus on debt-
dollarization as a proxy for CICR. As is shown in this study, these two terms are disconnected. Most
importantly, restricting the ability to lend in dollars would impose an important restriction to banks that use
dollar lending as a hedging mechanism to reduce currency risk. A regulation that focuses on debt
dollarization rather than on a measure of CICR would produce more harm than benefits, because it would
limit the banks’ ability to reduce risk by transforming currency risk into lower levels of CICR. In that regard,
the Peruvian experience, which focused on CICR, deserves more attention from other bank regulators.
6. References
Belloti, T., and Crook J. 2007 “Credit Scoring with macroeconomic variables using survival Analysis”
Bleakley, H., and Cowan, K. 2006. Maturity Mismatch and Financial Crises: Evidence from Emerging
Cowan K., Hansen E., Herrera L., 2005. “Currency Mismatches, Balance Sheet Effects And Hedging In
Carranza, L., Cayo J. and Galsón-Sanchez J. 2003. “Exchange rate volatility and economic performance
Cayazzo, J., Garcia Pascual, A., Gutierrez, E., and Heysen, S. 2006. “Toward an effective supervision of
partially dollarized banking systems. Working Paper 0632. Interamerican Development Bank
(IADB). January.
Ennis, H. 2000. “Banking and the political support for dollarization.” WP 00-12. Federal Reserve Bank of
Richmond.
Fuentes, Miguel. 2009. “Dollarization of debt contracts: Evidence from Chilean Firms” Developing
Galindo, A., Paniza, U., and Schiantarelli, F. 2003. “Debt composition and balance sheet effects of
currency depreciation: a summary of the micro evidence”. Emerging Markets Review, pages 330-
339.
Gulde, A., et al. 2004. “Financial stability in dollarized economies” Ocasional Paper 20. International
International Monetary Fund (IMF, 2001) “The Decline Of Inflation In Emerging Markets: Can It Be
Ize, A. and Powell, A. 2004. “Prudential Responses to De facto Dollarization” WP 04/66. Torcuato Di Tella.
Machicado C. 2008. “Liquidity shocks and the dollarization of a banking system”. Journal of
Magud N. 2009. “Currency mismatch, openness and exchange rate regime choice” Journal of
Reinhart, C. and Kaminsky, G. 1999. “The twin crisis: The causes of banking and balance of payment
Serieux, John. 2009. “Partial Dollarization, Exchange Rates, and Firm Investment In Paraguay”
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Note: PEN is the Peruvian Nuevo Sol denomination in the stock market. The highlighted area indicates the
period of high volatility due to electoral turbulence.
SIZE_SMALL Dummy that takes the value of 1 (one) if it is a small firm 0.974 0.160
BANKS Number of banks where the firm has a debt 2.391 1.381
COVERAGE Ratio of coverage (guarantee/debt within the base month) for the firm 50.284 8166.611
NPL Ratio of nonperforming loans in the financial system during the period 0.0191 0.116