DP15440 Foreign Currency Borrowing of Corporations as Carry Trades: Evidence from India
We establish that macroprudential policies limiting capital flows can curb risks arising
from corporate foreign currency borrowing in emerging markets. Using detailed firm-
level data from India, we show that propensity to issue foreign currency debt for the
same firm is higher when the difference in short-term interest rates between India and
the US is higher, i.e., when the dollar ‘carry trade’ is more profitable; this behavior is
driven by the period after the global financial crisis. The positive relationship between
issuance and the ‘carry trade’ breaks down once regulators institute more stringent
interest-rate caps on foreign currency borrowing. Riskier borrowers such as importers
and those with higher interest costs cut issuance most. Firm equity exposure to
foreign exchange risk rose after issuance in favorable funding conditions and emerged as
a source of external sector vulnerability during the ‘taper tantrum’ of 2013.
Macroprudential policy action limiting capital flows is able to nullify this effect, such as
during the market stress due to the COVID-19 pandemic.