Balance Sheet Effects Research Articles

Exchange rate volatility and economic performance in Peru: a firm level analysis

This paper analyzes the impact of the exchange rate volatility on the performance of the Peruvian economy using financial information from 163 non-financial listed firms. We find evidence that, for firms holding dollar-denominated debt, investment decisions are negatively affected by real exchange rate depreciation. The reasons behind this result are: (i) the high degree of liability dollarization and currency mismatch that create the conditions for a balance sheet effect and a financial stress in the aftermath of a currency depreciation; (ii) the strong bank-lending channel that follows and reinforces the balance sheet effect; (iii) the domestic demand shrinkage that affects severely firms’ sales; and (iv) the relatively small and poorly diversified export sector.

Debt composition and balance sheet effects of exchange rate depreciations: a firm-level analysis for Chile

By studying the behavior of foreign currency borrowing, maturity, sales and the investment decisions of firms listed in the Chilean Stock Exchange from 1994 to 2001, this paper assesses whether in the aftermath of the Asian crisis of the late 1990s the depreciation of the local currency (Chilean peso) affected these firms’ real and financial decisions. At issue is the contrast between a negative net-worth effect and a potential expansionary competitiveness effect for the tradable sector. We find that there exists little evidence that devaluations cause a positive impact on investment and sales for firms with dollar denominated debt. The maturity structure of Chilean firms is mainly explained by the size of the companies. Large firms will have a debt structure biased to higher maturities. Analyzing dollar denominated debt composition the evidence shows that larger firms maintained a higher proportion of dollar denominated debt reflecting the development of the financial sector in Chile.

Debt composition and balance sheet effects of exchange rate volatility in Mexico: a firm level analysis

We use Mexican firm-level data to study the role of currency mismatches in the corporate sector in exacerbating the negative effects of a devaluation. We also investigate what drives Mexican firms to borrow in foreign currency. We find that holding dollar denominated debt in a devaluation adversely affects firms’ earnings and investment. However, exporters invested more than non-exporters in the same period. We also find that the negative effect of dollar debt was stronger than the positive effect of exports in the 1994 crisis for firms with positive dollar debt and/or exports, relative to firms that did not borrow abroad and/or export. This was a result of imperfect currency matching by firms. However, in the 1998 crisis firms managed the denominations of their inflows and outflows much better and these two effects were roughly equal in magnitude. We also find some evidence of currency matching by exporters, especially after the introduction of the floating exchange rate.

Debt composition and balance sheet effects of currency depreciation: a summary of the micro evidence

This paper surveys recent empirical evidence on the determinants of the currency composition of debt, and on the impact of exchange rate fluctuations on economic activity. It suggests that Latin American firms tend to partially match the composition of their debt with the currency composition of their income stream but the liability dollarization can reduce or possibly reverse the typical Mundell–Fleming result of expansionary devaluations.

Financial dollarization and debt deflation under a currency board

In the late currency board years, Argentina faced a real exchange rate adjustment through price deflation amidst growing devaluation expectations. Using a firm-level panel database to analyze the incidence of these factors on the currency composition of private debt and on firms’ performance, we find that widespread debt dollarization showed no relationship with the firms’ production mix or the ever-changing probability of a nominal devaluation. While relative price changes favored export-oriented firms with the expected impact on sales, earnings and investment, increases in devaluation expectations elicited only a marginal differential response in investment from more financially dollarized firms. Our findings provide support to two criticisms faced by the Argentine currency board in recent years, namely, that by fueling beliefs in an implicit guarantee it stimulated across-the-board debt dollarization and that it could not fully isolate the economy from real shocks, as the feared balance sheet effect was replaced by a gradual but equally deleterious debt deflation effect.

Net Worth, Risk Taking and Investment

This paper analyzes how agency problems in financial contracting determine risk-taking and investment. In perfect capital markets a risk-neutral firm would invest until the expected marginal return equals the interest rate. However, as firms with little net-worth face agency cost in financial contracting the shadow cost of external funding are increased. It is often argued that this wedge forces firms to underinvest (the 'balance-sheet-effect'). However, this claim is premature. Firms with low net worth, hence high cost of external financing, might even overinvest. We establish a robust though more subtle balance sheet effect. Agency problems in financial contracting generate risk avoidance at the firm level even when all actors are risk neutral. This may explain why during major economic downturns firms and banks shun risks that could be accepted in better times.

Discussion of “The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Profitability”

Fairfield et al. (2003a, this issue) suggests that the accrual effect in Sloan (1996) is at least partly due to the fact that accruals signify an increase in (less-productive) net operating assets. Thus, the paper is a useful and thought-provoking reminder that accruals have both earnings and balance sheet effects. However, the impact of the empirical results is diminished by the lack of a convincing story that ties and grounds these results to other knowledge in the area. Sloan (1996) is an influential study, which documents a simple but important relation: the accrual portion of earnings is less persistent than the cash portion of earnings. In addition, Sloan finds that investors do not seem to fully appreciate the implications of accruals for future earnings, so that firms with high current accruals earn lower future stock returns. This study prompted a flurry of subsequent research which investigates the specific causes and explanations for this phenomenon. For example, Xie (2001) finds that the lower persistence of accruals is primarily due to the role of discretionary accruals, while Desai et al. (2002) argue that the accrual effect for stock returns is a variation on the ''value/glamor'' anomaly. Fairfield et al. (2003a, this issue), hereafter FWY, is another follow-up on Sloan (1996), which observes that the documented effects in accruals and cash flows concern variables scaled by some measure of investment (e.g., total assets). Thus, the documented lower persistence of scaled accruals could be due to one of two effects. First, it could be due to the lower persistence of unscaled accruals (a numerator effect), which is the commonly accepted explanation. Alternatively, FWY suggests that the lower persistence of scaled accruals could be due to the relation between accruals and growth in the investment base (a denominator effect). As the author points out, this alternative explanation seems promising because the concept of accruals is closely related to the concept of growth in assets. In fact, the commonly used balance sheet-based derivation of accruals reveals that the two concepts are at least somewhat mechanically related.

A Dynamic General Equilibrium Framework of Investment with Financing Constraint

In this paper, we provide a dynamic general equilibrium framework with an explicit investment-financing constraint. The constraint is intended as a reduced form to capture the balance sheet effects that have been widely regarded as an important determinant of financial crises. We derive a link between the value of a firm and social welfare. Using this link, we show the somewhat surprising possibility that the value of a firm can be greater with the constraint. Our model also sheds light on how the effects of productivity shocks and investors' misperception of productivity shocks may be amplified by the financing constraint. Copyright 2003, International Monetary Fund

Determinants of Deflation in Hong Kong SAR

This paper presents a comprehensive econometric analysis of the determinants of deflation in Hong Kong SAR. The analysis helps to determine the relative contributions of factors such as increased productivity, scarce money supply, and excess capacity in determining deflation. The main conclusion is that the effects of permanent shocks, such as productivity shocks and shocks related to changes in the money supply and price convergence with trading partners, have become more important in explaining deflation. In addition, the effects of temporary shifts in aggregate demand have been perpetuated by negative wealth and balance-sheet effects in the corporate and household sectors arising from asset-price declines over the past five years.

Determinants of Deflation in Hong Kong Sar

This paper presents a comprehensive econometric analysis of the determinants of deflation in Hong Kong SAR. The analysis helps to determine the relative contributions of factors such as increased productivity, scarce money supply, and excess capacity in determining deflation. The main conclusion is that the effects of permanent shocks, such as productivity shocks and shocks related to changes in the money supply and price convergence with trading partners, have become more important in explaining deflation. In addition, the effects of temporary shifts in aggregate demand have been perpetuated by negative wealth and balance-sheet effects in the corporate and household sectors arising from asset-price declines over the past five years.

IS-LM-BP in the Pampas

Emerging markets (sometimes endowed with fertile pampas) have limited access to world capital markets and suffer from original sin: "they cannot borrow in their own currency. Does this mean that monetary and exchange rate policies have non-standard effects in such countries? We develop a simple IS-LM-BP model with balance sheet effects to study that question. Our answer: it all depends.

The Credit Channel in Middle Income Countries

With inflation under control in many in middle income countries (MICs), it is now swings in credit, investment and asset prices that affect these countries the most. In this paper we present a framework to analyze both theoretically and empirically how credit market shocks are propagated and amplified in MICs.The strength of the credit channel in our model derives from two key characteristics of MICs: (i)a sharp asymmetry across the tradables (T) sector and the more bank-dependent nontradables (N) sector; and (ii)a significant degree of currency mismatch in the N-sector. This makes movements in the real exchange rate the driving element in the amplification of shocks. The equilibrium imposes unambiguous contemporaneous linkages among key macroeconomic variables and allows us to derive structural VARs. Estimating these VARs using quarterly data for a group of MICs, we find evidence for a strong credit channel, for a balance sheet effect and for asymmetric sectorial responses. Our findings indicate that inflation targeting is not sufficient to guarantee economic stability, as such policy might overlook the development of lending booms and associated sectorial asymmetries.

Balance-Sheet Contagion

Japan has been in a slump for the past decade. After GDP had been growing by on average 4 percent during the 1980’s, the growth rate dropped to 1 percent in the 1990’s. Asset prices also fluctuated significantly: capital gains on stocks and real estate in the 1980’s, followed by capital losses in the 1990’s, were both on the order of a few years’ worth of GDP, even after taking inflation into account. Together with production and asset prices, the fraction of nonperforming loans fluctuated substantially. These are by no means all bank loans. For the nonfinancial corporate sector in Japan, the ratio of financial assets to total assets is about 40 percent, much higher than in the United States. Such financial assets include loans to and securities of other private agents. That is, nonfinancial institutions simultaneously borrow from and lend to each other on a significant scale. Many nonperforming loans are interlocked, paralyzing the financial system. It is important to recognize that these swings have been experienced by almost all sectors of the Japanese economy. Yet in other countries, comparable movements in asset prices have had less widespread consequences. For example, the recent fluctuations in the NASDAQ index in the United States have been no smaller than those of asset prices in Japan, but the damage appears to be contained to closely related sectors. Although U.S. equity-holders, particularly pension funds, have lost value, the level of nonperforming loans is relatively limited up to now. The question is: Why does there appear to be more contagion in some countries than in others? Has contagion anything to do with the nature of financing or the extent to which there are inter-locking loans? In this theoretical paper, we examine two different mechanisms by which contagion may occur. In both cases, propagation is through balancesheet effects. First, through the indirect effects that fluctuations in asset prices have on collateral values. Second, through the direct effects that default on or postponement of debt repayments have when there are chains of credit.

A Dynamic General Equilibrium Framework of Investment with Financing Constraint

In this paper, we provide a dynamic general equilibrium framework with an explicit investment-financing constraint. The constraint is intended as a reduced form to capture the balance sheet effects that have been widely regarded as an important determinant of financial crises. We derive a link between the value of the firm and social welfare. We find that the value of the firm can be greater with the constraint. Our model also sheds light on how the effects of productivity shocks and investors' misperception of productivity shocks may be amplified by the financing constraint.

A Dynamic General Equilibrium Framework of Investment with Financing Constraint

In this paper, we provide a dynamic general equilibrium framework with an explicit investment-financing constraint. The constraint is intended as a reduced form to capture the balance sheet effects, which have been widely regarded as an important determinant of financial crises. We derive a link between the value of the firm and the social welfare and we find that the value of the firm can be greater with than without the constraint. Our model also sheds light on how the effects of productivity shocks and bubbles may be amplified by the financing constraint.

Improving Financial Reports by Revealing the Accuracy of Prior Estimates

Several researchers (e.g., Lundholm, 1999; Ryan, 1997; Petroni, et al, 2001) have proposed a reporting mechanism to enhance the reliability of estimates and other forward-looking information in the financial reporting process. Their proposal requires companies to report reconciliations of prior year estimates to actual realizations as supplemental information in their financial reports. Such disclosures would enable investors to distinguish between accurate and opportunistic reporting behavior, and arguably should create incentives for companies to accurately estimate in the first place. Our study provides evidence on these proposals to expand the reporting model. We develop predictions based on research in psychology and conduct an experiment within the context of an important intangible asset requiring estimation-software development costs. Our results show that the reporting mechanism proposed by Lundholm, Ryan, Petroni, and others is effective in communicating information about the accuracy of financial estimates. However, we find that all disclosures are not equally useful. The most-effective disclosures transparently describe the implications of misestimation (if any) on both the balance sheet and on earnings. Merely disclosing what the software development asset would have been (i.e., balance sheet effect only) under perfect foresight does not always lead investors to completely distinguish between accurate and opportunistic estimators. Our results also show that when the disclosures transparently describe the implications of misestimation, investors reward those who are accurate estimators but do not punish those who are inaccurate. We conclude that information about previous estimate accuracy is useful to investors, and that regulators should consider the transparency of disclosure formats, as all disclosures may not be equally effective in creating management incentives for accurate estimation. Further, the effectiveness of the proposed reporting mechanism for enhancing the reliability of financial reports appears to rest on the relative competitive advantage conferred upon firms that provide accurate estimates.

Balance Sheet Effects, Bailout Guarantees and Financial Crises

This paper provides a model of boom-bust episodes in middle-income countries. It is based on sectoral differences in corporate finance: the nontradables sector is special in that it faces a contract enforceability problem and enjoys bailout guarantees. As a result, currency mismatch and borrowing constraints arise endogenously in that sector. This sectoral asymmetry allows the model to replicate the main features of observed boom-bust episodes. In particular, episodes begin with a lending boom and a real appreciation, peak in a self-fulfilling crisis during which a real depreciation coincides with widespread bankruptcies, and end in a recession and credit crunch. The nontradables sector accounts for most of the volatility in output and credit. In the last two decades, many middle-income countries have experienced boom-bust episodes centred around balance-of-payments crises. There is now a well known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large fundamental shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output. This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle-income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults. The first part of this paper derives optimal investment and financing choices for the N-sector when these imperfections are present. We show that both borrowing constraints and a risky currency mismatch of assets and liabilities arise in equilibrium. Moreover, even in a world with no exogenous shocks, self-fulfilling crises can occur. The second part of this paper

Balance Sheets and Exchange Rate Policy

В статье анализируется связь между обменным курсом и балансом активов и пассивов и влияние этой связи на макроэкономические показатели в малой открытой экономике. Из-за высокой степени долларизации обязательств, обесценение национальной валюты, с одной стороны, снижает чистую стоимость компаний (net worth), что порождает финансовую хрупкость частного сектора. Это ведет к ограничению инвестиций. С другой стороны, девальвация приводит к расширению выпуска и росту отдачи от инвестиций, что также является компонентом чистой стоимости компании. В работе показывается, что негативный внешний шок может быть усилен эффектом баланса (balance sheet effect). В результате выпуск и инвестиции снижаются. При фиксированном курсе это падение сильнее, чем при плавающем. Таким образом, гибкий курс является лучим амортизатором внешних реальных шоков, даже несмотря на значительный эффект баланса.

Purchase versus pooling in stock-for-stock acquisitions: Why do firms care?

We investigate firms’ choices between the purchase and pooling methods in stock-for-stock acquisitions. We find that in acquisitions with large step-ups to targets’ net assets, CEOs with earnings-based compensation are more likely to choose pooling and avoid the earnings ‘penalty’ associated with purchases. We find no association between stock-based compensation and the purchase–pooling choice, suggesting that managers are not concerned about implications of large step-ups for firms’ equity values. We also find that the likelihood of purchase increases with debt contracting costs, consistent with its favorable balance sheet effects, and with costs of qualifying for pooling, particularly the restriction of share repurchases.

Purchase versus Pooling in Stock-for-Stock Acquisitions: Why Do Firms Care

We investigate firms' financial reporting policies with respect to business combinations, particularly the choice between the purchase and pooling-of-interests methods. To control for potentially confounding effects related to the method of acquisition financing, we focus on a sample of stock-for stock acquisitions. We provide evidence that the accounting method choice is jointly determined by the size of the step-up, i.e., the premium paid over the book value of the acquired firm and which is recognized under the purchase method, and proxies for economic benefits derived from accounting-based contracts. In particular, we find that, when the business combination involves a large step-up to the target's net assets, CEOs with earnings-based compensation plans are more likely than others to incur the costs of qualifying for pooling and avoid the earnings 'penalty' associated with the purchase method. However, we find no association between stock-based compensation and the purchase-pooling choice, suggesting managers are not concerned about implications of large step-ups for firms' equity values. We also find no support for the prediction that top executives' preference for pooling is greater when their job security is relatively low. Finally, consistent with the favorable balance sheet effects of the purchase method, we find that the likelihood of pooling decreases with the acquirer's debt-equity ratio, a proxy for debt contracting costs. We also predict and find an association between the purchase-pooling choice and potential costs related to meeting the restrictive pooling criteria. In particular, we find that firms for which the pooling requirement of no share repurchases appears to be binding (firms that have already announced a share repurchase plan and/or have a large number of outstanding employee stock options) are less likely than others to use pooling. However, we do not find that firms for which the requirement of no post-acquisition divestitures of the target's assets may be binding are less likely to use pooling.