1

The external financial restriction

Esteban Pérez Caldentey1

This draft 15 March 2021

PLEASE DO NOT CITE

Abstract
This paper argues that the existing international currency hierarchy imposes two types of
external restrictions on developing countries. The first is captured by the balance-of-
payments-constrained-growth literature, which focuses on the limits imposed by current
account imbalances on countries policies to attain full employment of resources. The
second is the financial external restriction. The paper explores the types of transmission
mechanisms that lead to the existence of a financial constraint. More specifically it focuses
on the relationship between country risk perception and nominal exchange rate variations.
The positive association and causality between both not only limit the space of fiscal policy
and monetary policy but has also important implications for the fragility of the non-
financial corporate sector and the behavior of investment.

1
Chief of the Financing for Development Unit (Economic Development Division). Economic Commission for Latin
America and the Caribbean (Santiago, Chile). [email protected]
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1. Introduction
This paper is part of work in progress that purports to show the importance of the financial
external restriction that significantly limits developing countries’ space to pursue countercyclical
expansionary policies. The paper starts by showing that the workings of the international economy
is anchored on developed countries’ currencies and, in particular on the role of the United States
dollar. The largest share of international real and financial transactions is denominated in United
States dollars.
The existing currency hierarchy imposes both a real and financial external constraint. The first
constraint is captured by the balance-of-payments constrained-growth literature. The paper
explores the types of transmission mechanisms that lead to the existence of a financial constraint.
More specifically, it focuses on the relationship between country risk perception and nominal
exchange rate variations. The positive association and causality between both not only limits, the
space of fiscal policy and monetary policy, but has also important implications for the fragility of
the non-financial corporate sector and the behavior of investment.
This paper is divided into eight sections. The second and third sections focus on the existing
currency hierarchy and its implications for the importance of monetary policy in the United and
its impact on developing countries. These two sections set the stage for the argument that currency
hierarchy not only results in an external constraint on the real side of the balance of payments but
also on the financial side of the external accounts. Moreover, it may well be the case that the
financial external constraint bites before the external constraint (reflected in the current account)
does. The fourth and fifth sections center on the relation between currency hierarchy and the
balance-of-payments constraint (the external ‘real side’ constraint). Sections six to eight focus on
the mechanisms through which currency hierarchy leads to a financial external constraint. The
implications for countercyclical policy and growth are analyzed.

2. The existing currency hierarchy

The economic organization and workings of the international economy is largely based on the
importance of developed countries’ currencies and more specifically on the United States dollar.
International economic and financial transactions revolve around the United States dollar.
With a 15% share of global GDP, the United States dollar accounts for a large share of the
issuance of securities, global official international reserves, and the external debt of emerging
economies are denominated in dollars. The global financial crisis (2008-2009) and the COVID-19
crisis have reinforced the dollar’s hegemony as the main international reserve currency.
Worldwide, around 80% of international transactions are conducted in dollars. 2 Also half of

2
Calculations based on BIS (2019) show that, in 2018, in emerging markets and developing economies, dollar-
denominated debt accounted for 80% of total issuance in emerging markets and developing economies: 76% in
developing countries in Europe; 78% in developing countries in Asia and the Pacific; 84% in developing countries in
Africa and the Middle East; and 90% in developing countries in Latin America and the Caribbean.
 3

international trade is invoiced in dollars, representing more than five and three times the United
States' share of total world imports and exports (Carney, 2019).
This situation creates mechanisms that reinforce the dollar's dominance globally. The
importance of the dollar in international transactions generates a growing demand for dollar-
denominated assets that, coupled with its increased liquidity and security, reduces its return by
generating a greater incentive for holding and demanding dollars, and as a corollary to dollar debt.
In turn, the need to cover foreign currency gaps and mismatches, implies an increase in dollar
transactions.

3. Currency hierarchy and the importance of the monetary policy of the United States
Generally, the existence of a currency hierarchy has been analyzed from the perspective of the
role that the United States’ Federal Reserve has to dictate global monetary policy without the need
for explicit coordination with other central banks and to impose the costs of its policies on other
countries, and in particular on emerging and developing economies.
The impact of the United States’ monetary policy is particularly pronounced when a significant
proportion of debt is denominated in US dollars, as is the case in the case of some governments
and the non-financial corporate sector in Latin America. Changes in monetary policy (when
contractionary) drive up debt servicing costs, principal payments and the cost of a potential
refinancing.
The US monetary policy transmission channel has been reinforced due to the growing
importance of the international capital (bond) market that represents more than 50% of global
liquidity. In fact, as shown below, the bond market provides a stronger transmission channel of
United States monetary policy than commercial bank’s cross-border loans.
Changes in monetary policy primarily affect debtors (borrowers) and bondholders are affected
by the inverse relationship between a bond’s price and the interest rate. The yield on a bond is
equal to the dividend received plus the change in price (Yield=Interest+(Pt1 -Pt2 ). For a given
interest rate (taking into account, as noted above, that the bulk of international bond issues are
fixed interest), a decrease in a bond’s price between two points in time (𝑡 and 𝑡 ) reduces its yield
and results in a capital loss for bondholders. Under certain circumstances, this may reduce the
incentive to retain bonds as assets and thus limit the potential to use the bond market as a borrowing
and financing mechanism.
Global econometric information for a set of 49 countries for the period 1995–2018 shows that,
as is to be expected, the federal funds rate has an inverse relationship with credit flows and debt
securities. However, the impact tends to be greater when considering only debt securities. Other
variables that can hamper credit flows are the level of volatility, as measured by the Chicago Board
Options Exchange (CBOE) Volatility Index (VIX), and sovereign risk. More specifically, a 25-
basis-point rise in the rate results in an 80-basis-point reduction in credit flows to banking
institutions. Furthermore, the impact is more significant for debt securities, which fall by 100 and
66 basis points in case of financial and non-financial corporations, respectively. This causation is
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replicated in the countries of Latin America and the Caribbean and in emerging economies 3. In the
case of Latin America, the results indicate that a 25-basis-point hike in the federal funds rate results
in an 86-basis-point drop in credit flows, and a similar situation for debt securities issued by
financial corporations, whose growth rates plunge 794 basis points.
The existing currency hierarchy is also present in the way the United States Federal Reserve
has turned to its temporary repurchase agreement facility for foreign and international monetary
authorities and extended dollar repurchase agreements to protect its monetary policy during the
COVID-19 crisis. Both instruments seek to prevent excess demand for dollars outside the United
States from leading central banks in other countries to sell some of their holdings of United States
Treasury bonds (which are the most liquid asset in the money market) to avoid a potential liquidity
crisis.
By causing a decline in treasury bond prices and a rise in long-term interest rates, the sale of
treasury bonds can compromise monetary policy objectives and in particular those relating to
quantitative easing. Other purposes of the programmes to provide dollar liquidity for non-residents
are: (i) to avoid an overvaluation of the dollar, which would have a negative effect on exports of
goods and services, and increase the liabilities for non-resident agents and institutions with foreign
currency debt, and (ii) to facilitate trade transactions by United States offshore companies and
foreign financial institutions operating in the United States.
Fourteen central banks are participating in dollar repurchase agreements: Bank of Canada,
Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, Reserve Bank of
Australia, Central Bank of Brazil, Bank of the Republic of Korea, Bank of Mexico, Monetary
Authority of Singapore, Bank of Sweden, National Bank of Denmark, Bank of Norway and
Reserve Bank of New Zealand.4 These banks are among the largest holders of United States

3
The aim was to identify the determinants of financial flows in the world and towards Latin America and the
Caribbean. To this end, a panel of quarterly data was compiled on financial flows into 49 countries from around the
wold and 12 in Latin America and the Caribbean, for the period 1995–2018. Two databases were used, from the Bank
for International Settlements (BIS) “Locational banking statistics” and “Debt securities statistics” (BIS, 2019).
Meanwhile, for the global factors, global quarterly GDP figures were used for member countries of the Organization
for Economic Cooperation and Development (OECD), supplemented by the quarterly GDP figures produced by
ECLAC for non-OECD countries. The second global factor is change in United States monetary policy, in other words
the short-term federal funds rate. For example, the VIX Volatility Index is included as a measure of global risk levels.
To capture the determinants by country, consideration was given to quarterly GDP (from OECD and ECLAC), capital
account openness (Chinn-Ito Index), sovereign risk rating (averages for Moody’s, Standard & Poor’s and Fitch) and
a macroprudential policy index (Cerutti, Claessens and Laeven, 2018). In formal terms, the model is described as:

𝐹 = 𝐵 + 𝐵 ∆𝐹𝐹𝑅 + 𝐵 𝑉𝐼𝑋 + 𝐵 𝑃𝐼𝐵𝑃𝑎í𝑠 + 𝐵 ∆𝑅𝑎𝑛𝑘𝑖𝑛𝑔𝑆𝑜𝑏

+ 𝐵 𝐶ℎ. 𝑖𝑡𝑜𝑖𝑛𝑑𝑒𝑥 + 𝐵 𝐺𝑙𝑜𝑏𝑎𝑙𝐺𝐷𝑃 + 𝐵 𝑀𝑃𝐼𝑁𝐷𝐸𝑋 + 𝛾 + 𝛿 + 𝑒

The model takes into account the fixed effects by year and country, the federal funds rate and the sovereign rating are
first differences, and the dependent variable 𝐹 is the rate of growth in cross-border credit or debt securities for country
i and quarter t.
4
These swap lines provide liquidity of up to US$ 60 billion each for Reserve Bank of Australia, Central Bank of
Brazil, Bank of the Republic of Korea, Bank of Mexico, Monetary Authority of Singapore and Bank of Sweden, and
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Treasury bonds (totalling 33 countries),5 and together they hold about 60% of these bonds outside
United States territory.

4. Currency hierarchy and the balance-of-payments constraint

Besides the direct impact that United States monetary policy can have on developing
economies, another aspect of currency hierarchy refers to the ability of developing countries to
pursue full employment policies in the presence of an external constraint. The most well-known
approach is the balance of payments constraint which mainly on the real side, that is the
consequences of demand expansion for the current account of the balance of payments.
The growth performance of developing economies depends on the organization of the existing
international financial order. Given the limitations of their productive structure, they depend to an
important extent on their availability to generate sufficient foreign exchange to cover their daily
transactions and long-term development needs. These include imports, interest payments as well
as profit transfers. Given that they do not issue a reserve currency -a means of payment universally
accepted - developing countries must earn foreign exchange through trade and by tapping on
international capital markets.
Developing economies need to import capital equipment, machinery, raw materials and inputs
such as oil and natural gas to build up their infrastructure, improve their productive capacity and
increase their growth potential. As a result, their economic performance depends on the extent to
which they can dispose of sufficient foreign exchange to finance their goods and services import
needs. In other words, their exports and their inflow of foreign capital must be commensurate to
meet the import needs compatible with their requirements for social and economic development.
This explains to a large extent why developing countries cannot sustain for long-current
account deficits. A simple exercise for Latin American and Asian economies considering what is
by historical standards a low and high current account threshold level, 2.5 and 7 percent of GDP,
respectively, shows that few countries are able to maintain over time a low level of a current
account deficit and that no country is able to maintain a high level of the current account deficit.
As shown in Figure 1 for Latin American and Asian economies there is an inverse relationship in
both cases between the number of recorded cases of current account deficits of 2.5 and 7 percent
of GDP and the number of years during which these deficits were sustained.

up to US$ 30 billion each for National Bank of Denmark, Bank of Norway and Reserve Bank of New Zealand (see
Board of Governors of the Federal Reserve System, 2020).
5
See United States Department of the Treasury (2020).
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Figure 1

5. The balance-of payments constrained growth model

The balance-of-payments constraint approach to growth specifies the conditions for under full
employment equilibrium in an open economy. This approach given pre-eminence to exports over
the rest of the autonomous components of aggregate demand. It is the only component of aggregate
demand that can sustain an increase in economic growth over time. As put by Thirlwall (2013,
pp.36-37):
"…fast export growth allows all other components of demand to grow faster because
exports can pay for the import content of consumption, investment, government
expenditure and exports themselves. Exports are unique in this respect compared to the
growth of other components of aggregate demand. Second, fast export growth allows fast
import growth which is important for developing countries that cannot produce for
themselves many of the goods, particularly capital goods, required for development. So,
fast export growth has both demand and supply- side effects conducive to growth."
More precisely, in an equilibrium position such as that defined by the balance-of-payments
constraint approach to growth, the flow of income generated internally and that derived from
external demand cannot be independent of each other. Either internal demand adjusts to conform
with the external performance, or the other way around.
In the balance-of-payments constraint growth approach, internal conditions adapt to those of
the external sector. This important idea is implicit in the balance of payments constraint approach
(Thirlwall, 2002, p. 53: "If there are no export earnings to pay for the import content of other
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components of expenditure, demand will have to be constrained") but is rarely made explicit in the
formal derivation of the model.
The balance of payments constrained growth literature postulates that the long term rate of
growth is determined by the combined influence of its import requirements, the demand and
composition of its exports, its capacity to attract foreign capital and the evolution of the real
exchange rate.
The balance-of-payments constrained rate of growth is expressed as:
𝜃𝜀𝑧 + (1 − 𝜃)(𝑓 − 𝑝 ) + (1 + 𝜃𝜂 + 𝜓)(𝑝 − 𝑝 − 𝑒)
(1) 𝑦 =
𝜋
Where,
𝑧= rate of growth of the rest of the world ; 𝑝 , 𝑝 , 𝑒= rates of growth of the domestically produced
good, of the imported good and of the nominal exchange rate; 𝜂, 𝜓 = price elasticities of demand
for exports and imports; (𝜂, 𝜓 < 0);𝜀, 𝜋= income elasticities of demand for exports and imports,
(𝜀, 𝜋 > 0); 𝑓 − 𝑝 = rate of growth of financial flows in real terms; 𝜃, (1 − 𝜃) = the share of
exports as a proportion of total receipts (exports and financial flows (these include unilateral
current transfers)).
Eq. (1) shows that balance-of-payments constrained grwowth depends on four sets of
factors: external growth(𝜃𝜀𝑧), the rate of variation in relative prices (i.e., price competitiveness)
(1 + 𝜃𝜂 + 𝜓)(𝑝 − 𝑝 − 𝑒), growth in financial flows (1 − 𝜃)(𝑓 − 𝑝 ), and the income elasticity
of imports (𝜋).
Developing countries must grow at rates commensurate with these external requirements.
It is in this sense that they are balance of payments constrained. More precisely "countries face an
external constraint when their performance in foreign markets and the response of the financial
markets to this performance restrict growth to a rate lower than external conditions require." 6 The
BOP constraint implies that the economy grows at a rate lower than the one compatible with full
employment.
Or what is the same thing, long-term growth of an economy is balance-of-payments
constrained if the rate of growth consistent with a balanced current account or more precisely with
a balanced basic balance (current account plus net long-term flows) fall below the rate of growth
determined by the maximum expansion of output from the supply side. This includes the growth
of the labor force, the rate of accumulation of fixed capital, and the rate of growth of technical
progress as a function of the rate of growth of output and Verdoorn’s Law (McCombie, 2009).
That is,
(2) 𝑦 > 𝑦 ≥𝑦

6
McCombie and Thirlwall (1999, p. 49)
 8

Where 𝑦 = growth in productive capacity (the maximum growth rate determined by supply);
𝑦 = the rate of growth of current output; 𝑦 = the rate of growth consistent with balance-of-
payments equilibrium.
Balance-of-payments constrained growth implies the existence of excess capacity, low
rates of accumulation and of technical progress and the existence of unemployment and
underemployment. The degree and binding character of the balance-of-payments constrained
depends on the characteristics of a given economy as well as of the existing external context. In
fact, the external constraint manifests itself with particular strength, in those countries that do not
issue a reserve currency but that are highly dependent on it for their productive development.
This approach underscores the limitations imposed in the long-run to aggregate demand
expansion by external conditions. There are five ways in which the external constraint on growth
can be eased: (i) a permanent increase in the rate of growth in external demand, (ii) a permanent
improvement in the terms of trade, (iii) a persistent depreciation of the real exchange rate, (iv) the
implementation of policies for structural change in the countries of the periphery, and (v) a
permanent increase in the rate of growth in long-term financial flows. The sustainable policy to
overcome the balance-of-payments constraint is through structural change.

6. The external financial restrictions: transmission mechanisms

Changes in fiscal and/or monetary policy not only affect the current account of the balance-of-
payments through changes in aggregate demand. These also affect the financial account of the
balance-of-payments giving rise to a financial cycle that also has important consequences for the
behavior of both financial and real variables.
One of the ways in which fiscal and/or monetary policies impact on the financial account of
the balance of payments is through the interaction between risk and nominal exchange rate
variations. As illustrated in Figure 1, in the cases of six Latin American economies (Argentina,
Brazil, Chile, Colombia, Mexico and Peru for the period 2000-2020) the rate of variation of the
nominal exchange rate is positively (and statistically significant) correlated with the rate of
variation of the emerging market bond index (EMBI) (the difference between the interest rates on
dollar-denominated bonds issued by emerging countries and United States Treasury Bonds,
considered risk-free) which is a reflection of country risk. 7
As a result, depreciations (appreciations) in the nominal exchange are accompanied by a
worsening (an improvement) of risk perceptions. The available empirical evidence points towards
a causality running from the nominal exchange rate to the EMBI (BIS, 2009), although there is no
reason to believe that the causality could not also run from the EMBI to the exchange rate (Figure
2).

7
The EMBI is based on the behaviour of the external debt issued by each country. The less certain a country is to
meet its obligations, the higher its EMBI will be, and vice versa. The lowest rate an investor would require to invest,
in a particular country would be the United States Treasury Bond rate plus the country’s EMBI.
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Figure 2 Latin America (6 countries):

Rate of Change of Emerging Market Bond Index (EMBI) (RED) and nominal exchange rate (BLUE), 2000–2020

Source: Abeles, Pérez Caldentey and Porcile (2021). Prepared by the authors, on the basis of J.P. Morgan, “EMBI Spreads”, 2020; and Economic Commission
for Latin America and the Caribbean (ECLAC), Economic Survey of Latin America and the Caribbean, 2020 (LC/PUB/2020/12-P), Santiago, 2020. In the case of
Argentina, the variables are expressed in terms of levels. The right scale measures basis points. r= simple correlation coefficient.
 10

7. The external financial restrictions and countercyclical fiscal policy

The dynamics between nominal exchange rates and the EMBI has important implications for
countercyclical fiscal policy. An increase in government expenditure and in the public deficit can,
under given, circumstances lead to increased risk perceptions, that is to a rise in the EMBI. The
rise in the EMBI not only increases the cost of borrowing in external financial markets but also
results in a depreciation of the exchange rate which can increase the burden of debt in foreign
currency.
This transmission mechanism takes on particular relevance in the current Pandemic context.
International bond market momentum has opened up an important source of financing (as noted
in the case of the public sector in Latin America and the Caribbean). At the same time, it has
exacerbated financial vulnerability by increasing debt levels which were already historic prior to
the outbreak of the pandemic.
In 2020, global debt is estimated to increase by US$ 15 trillion relative to 2019 and to reach
US$ 277 trillion (365% of global GDP). confirmed.The breakdown by sector for the third quarter
of 2020 shows that government and non-financial corporate sector debt represent 58% of the total
(29% each). Financial sector and household debt represent 24% and 18% of total debt, respectively
(IIF, 2020). Developed economies and emerging and developing economies account for 73% and
27% of the debt stock, respectively.
The emerging and developing economies that have recorded the largest increase in debt-to-
GDP levels between the fourth quarter of 2019 and the third quarter of 2020 are: China (30%),
Malaysia (25%), Turkey (25%), Colombia (22%), the Russian Federation (20%), the Republic of
Korea (19%) and Chile (17%). For the same period, the sectoral analysis of Latin America and the
Caribbean shows that the debt of the financial sector, the government, the non-financial corporate
sector and households increased from 28.4% to 35.5%, from 68.4% to 73.7%, from 38.2% to
43.3% and from 24.1% to 26.5% of GDP, respectively. Analysis at the country level indicates that
Chile and Brazil are the most indebted economies in the region (263% and 229% of GDP in the
third quarter of 2020, respectively). 8
The increase in debt in emerging economies, in a context of economic contraction (all
regions of the developing world are expected to experience a decline in GDP in 2020 compared to
2019), may generate not only liquidity problems but also insolvency. This is reflected in the
downgrading of the sovereign debt ratings of 36 countries around the world since the beginning of
the pandemic.9 Moreover, even in the absence of an insolvency problem, indebtedness may result
in higher debt service. Estimates indicate that sovereign debt service for emerging and developing
economies will increase from 7% of government revenues in 2019 to 10% in 2020 (IIF, 2020).
This restricts the use of public spending to strengthen economic and social development.

8
In the case of Brazil, debt is concentrated in the government sector and in Chile in the non-financial corporate sector
(41% and 46% of the total, respectively).
9
The credit rating downgrades correspond to those made by Fitch Ratings which, together with Moody’s and Standard
& Poor’s, dominates the global credit rating market.
 11

A more detailed analysis of Latin America and the Caribbean shows that 17 countries issued
bonds between January and October 2020 worth US$ 122 billion, which exceeds the amount issued
for the entire year in 2019 (US$ 118 billion). The breakdown by issuer shows that the government
sector is the main issuer, followed by the corporate-financial sector and the financial sector (59%,
27% and 10% of the total, respectively). This is explained by the strong impact of COVID-19 on
public sector financing needs owing to increased spending to address the health emergency and to
support households and businesses, along with the drop in income resulting from social
containment and isolation measures.

Figure 3
Variation in international bond market debt stock for emerging market economies and Latin
America and the Caribbean
First quarter of 2001–fourth quarter of 2020
(Percentages)

25

20

15

10

-5

-10
31/03/2001
30/09/2001
31/03/2002
30/09/2002
31/03/2003
30/09/2003
31/03/2004
30/09/2004
31/03/2005
30/09/2005
31/03/2006
30/09/2006
31/03/2007
30/09/2007
31/03/2008
30/09/2008
31/03/2009
30/09/2009
31/03/2010
30/09/2010
31/03/2011
30/09/2011
31/03/2012
30/09/2012
31/03/2013
30/09/2013
31/03/2014
30/09/2014
31/03/2015
30/09/2015
31/03/2016
30/09/2016
31/03/2017
30/09/2017
31/03/2018
30/09/2018
31/03/2019
30/09/2019
31/03/2020
30/09/2020
Emerging markets and developing economies Latin America and the Caribbean

Source: on the basis of Bank of International Settlements (BIS) (2021)

The financial vulnerability of governments is compounded by an analysis of the sovereign

ratings by the three major credit rating agencies (Moody’s, Standard and Poor and Fitch) which
shows that more than half of the economies for which data is available are classified with the wort
ratings (substantial risk and speculative grades). These include the majority of smaller economies
in the region and some of those that were is a weaker position prior to the Pandemic (i.e. Argentina)
(Table 1).
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Table 1
Credit ratings for Latin America and the Caribbean sovereign debt for selected countries
January 2021
Substantial risk Highly Speculative Speculative Medium grade
Argentina Bolivia The Bahamas Chile
Barbados Costa Rica Brazil Colombia
Belize Dominican Republic Guatemala Mexico
Ecuador Honduras Paraguay Panama
Venezuela Jamaica Peru
St. Vincent and the El Salvador Uruguay
Grenadines
Suriname
Note: The data is provided for the classification of Moody’s, Standard and Poor and Fitch. The credit ratings are
ordered from the worst (substantial risk) to the best credit rating (medium grade)
Source: https://countryeconomy.com/ratings

During 2020, thirteen Latin American countries (including Argentina, The Bahamas, Belize,
Bolivia, Colombia, Costa Rica, Ecuador, Guatemala, Jamaica, Mexico, Nicaragua, Suriname and
Trinidad and Tobago) witnessed credit rating downgrades.
But even if the government IS not indebted in foreign currency, the mechanism described
above still holds. The issue does not revolve around the currency in which the debt is denominated
per se. It is rather a question of who owns the debt. If debt is issued in domestic currency but it is
owned by foreign investors, a an effective or expected depreciation may have similar effect in the
economy as if the debt were issued in foreign currency. It can lead to expected capital losses of
the foreign investors who owns the debt denominated in domestic currency. This will result in
capital outflows and increased risk perceptions (a rise in EMBI). If risk perceptions affect in turn
the exchange rate this mechanism can provide the basis for a cumulative process. The available
evidence points that, in some countries of Latin America, a important part of government debt is
owned by foreign investors (Figure 4).
Figure 4
Foreign and domestic ownership of sovereign debt by issuer
Selected LAC countries 2013 (percentage of total)
100
85.0
80 66.6 69.9
59.7
60 49.5 50.5
40.3
40 33.5 30.1
20 15.0

0
Argentina Brazil Colombia Mexico Peru

Foreign Domestic

Source: World Bank (2018)

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8. Non-financial corporate sector, hedging and arbitrage

The dynamics between the exchange rate and risk perceptions are compounded in the case of
the non-financial corporate sector. The non-financial corporate sector in emerging and developing
market economies tends to operate with currency mismatches. Moreover, the available evidence
shows that currency mismatches have widened over time.
Table 2
Net foreign currency assets of the non-government corporate sector as percentage of exports
for selected emerging market economies 2007-2014 (in percentages)

Note: The values of the net foreign currency assets of the non-government corporate sector are computed as "net
foreign assets of depository corporations (excluding central bank) plus non-bank foreign currency cross-border assets
with BIS reporting banks less non-bank foreign currency cross-border liabilities (excluding debt securities) to BIS
reporting banks less international debt securities outstanding of non-bank and non-government sectors in foreign
currency; outstanding position at year-end."
Source: Chui et. al (2016.Table A2)

This arises out of a simple but forgotten fact. As a result of the existing currency hierarchy,
dominated by the reserve currency status of developed economies and in particular of the United
States dollar, assets denominated in different currencies are imperfect substitutes. This idea is
independent of the degree of capital mobility. As explained by Smithin (2012, p. 166): "Even given
‘perfect capital mobility’ there nee not be ‘perfect asset substitutability’. It continues to
matter…whose promises to pay the investor holds, at any given moment." Imperfect asset
substitutability means that agents cannot arbitrage financial operations with currencies
denominated in different currencies and that therefore they cannot hedge their positions.
Currency mismatch makes the non-financial corporate sector vulnerable to changes in the
nominal exchange rate an also to risk perceptions. The depreciation of local currencies can affect
firms’ financial situation. Depreciation not only raises debt service costs, and thence outgoings,
but also swells liabilities by increasing the local-currency value of outstanding debt. If the
collateral for the debt is likewise denominated in local currency, depreciation will also cause this
 14

asset to lose value. This can give rise to a mismatch such that the firm has to purchase currency to
balance its accounts. Depending on its size and importance in the market and the number of firms
behaving in this way, currency purchases can create further pressure for devaluation of the nominal
exchange rate, ultimately increasing the external debt of the firms operating in the non-tradable
goods sector.
This transmission mechanism is also affected by the degree of foreign-currency leverage
in the non-financial corporate sector and how this affects the sector’s investment decisions.
The evidence shows that in a situation where firms are over-leveraged, they restrict their
investment and increase their cash holdings to protect against potential situations of lack of
liquidity and insolvency. This result is particularly relevant for issuers on the international bond
market, since over 50% of these firms have leverage ratios of over 0.80 and represent a large
proportion of total assets and investments.
An econometric estimation that relates investment in tangible assets to cash flow by degree
of leverage for 270 firms in six Latin American countries (Argentina, Brazil, Chile, Colombia,
Mexico and Peru) for the 2010–2016 period, shows that when leverage exceeds a 0.77 threshold,
a 1% increase in cash flow-to-assets is associated with a reduction in investment of 0.25%–0.24%.
In terms of the growth of tangible assets, the estimated equation shows that when leverage exceeds
the 0.77 threshold a 1% increase in cash flow-to-assets is associated with a 0.75% reduction in the
rate of growth of tangible assets (Pérez Caldentey, Favreau-Negront and Méndez, 2019).
Leverage thresholds above which firms choose not to invest are likely to remain constant over
time and tend to decline in periods of uncertainty, lower expectations and weak growth. This
situation may lead to a cycle characterized by low levels of investment and growth, together with
high levels of debt. These conditions may then impose a severe funding constraint if asset
managers decide to reduce their positions in corporate non-financial sector bonds in international
markets.
The conditions may be aggravated by the role played in financial intermediation by the non-
financial corporate sector, through the corporate debt issued by subsidiaries resident abroad. If that
role is important, the effective foreign currency debt may be greater than that declared according
to residence criteria, which makes the firm more financially fragile, while restricting financing. If
revenues from debt issuance are channeled into the financial system and form part of an economy’s
liquidity, this could be restricted.
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