Essays in Honour of Horst Hanusch
Edited by Andreas Pyka, Uwe Cantner, Alfred Greiner and Thomas Kuhn
Chapter 7: Corporate Currency Hedging and Currency Crises
* Andreas Röthig, Willi Semmler and Peter Flaschel 1. INTRODUCTION One of the key ingredients in financial crises according to Krugman (2000) is foreign-currency-denominated debt. Given such sort of debt, a sudden currency depreciation – a rising price of foreign exchange – could have serious consequences for the balance sheets of firms. Those negative balance-sheet effects may cancel out positive effects arising from the trade balance, as described by the Marshall-Lerner condition. Krugman (2000) sketches two possible solutions for avoiding financial crises. The first is based on a growing integration of markets for goods and services. This would weaken the contractionary balance-sheet effect of a currency depreciation and strengthen the positive effects on exports. The second solution concerns encouraging foreign direct investment. Multinational firms, which have subsidiaries in different countries and deal with a portfolio of different currencies, are more likely to resist pressures arising from a specific currency. Promoting foreign direct investment serves to reduce negative effects of adverse trends in foreign exchange markets. Hence both solutions focus on strengthening the independence of a firm’s balance sheet in respect of adverse exchange rate movements. This chapter pursues a new approach for reaching this objective. The main idea is that some independence of a firm’s balance sheet from adverse exchange rate movements can be achieved by corporate risk management. In contrast to our firm-based approach, other authors, such as Burnside et al. (2001), focus on the role of banks in currency crises. These authors investigate the conflict between government guarantees and banks’...
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