Currency Denomination of Bank Loans: Evidence from Small Firms in Transition Countries

We examine the firm-level and country-level determinants of the currency denomination of small business loans. We introduce an information asymmetry between banks and firms in a model that also features the trade-off between the cost of debt and firm-level distress costs. Banks in our model don’t know the currency in which firms have contracted their sales. When foreign currency funds come at a lower interest rate, all foreign currency earners and those local currency earners with low distress costs choose foreign currency loans. With imperfect information in the model concerning the currency in which the firms receive their earnings, even more local earners switch to foreign currency loans as they do not bear the full cost of the corresponding credit risk. We test these implications of our model by using a 2005 survey with responses from 9,655 firms in 26 transition countries that contains reports on 3,105 recent bank loans. We find that firms with foreign currency earnings and lower distress costs borrow more in foreign currency, while opaque firms do not. Interest rate advantages on foreign currency funds do explain differences in loan dollarization across countries, but not within countries over time. The presence of foreign banks and reforms related to corporate governance also contribute to differences in foreign currency borrowing across countries. However, stronger foreign bank presence or corporate governance do not lead more local currency earners to choose foreign currency loans. Our results suggest that while the cost and risk of debt do affect the propensity of small firms to take unhedged foreign currency loans, firm opaqueness does not. Hence, we cannot confirm that information asymmetries are a key driving force of the recently observed increase in loan dollarization in Eastern European transition countries.