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FRIC Center for Financial Frictions and The Department of Finance are proud to announce the upcoming seminar with Lorena Keller, Northwestern University, Kellogg School of Management

Title: Capital Controls and Risk Misallocation: Evidence from a Natural Experiment

Abstract
Foreign currency debt has led to many crises in emerging markets.Ìý However, in the past decade, firms in emergingeconomiesÌý haveÌý drasticallyÌý increasedÌý theirÌý foreignÌý currencyÌý borrowing,Ìý makingÌý themÌý significantlyÌý exposedÌý todepreciation shocks.Ìý To reduce their exposure to external shocks, central banks have increased their use of capitalcontrols.Ìý In this paper I study whether capital controls can have the unintended consequence of inducing firms toborrow more in foreign currency. I exploit heterogeneity in the strictness of capital controls across Peruvian banks toprovide novel causal evidence of the effect of capital controls on local firms’ dollar borrowing from banks.Ìý Using aunique dataset that includes all foreign exchange transactions and loans given by Peruvian banks, I find that capitalcontrols encourage firms to take more foreign currency loans.Ìý I describe a new mechanism to explain these findings,in which capital controls induce local banks to shift exchange rate exposure away from foreigners and onto domesticfirms. This is worrisome as the literature shows that depreciation shocks have led to significant reductions in investmentand employment for these firms.

Paper

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