Impact of Devaluations on Commodity Firms

A key factor determining whether crisis-country firms benefit from devaluations is whether the cost advantage from cheaper labor outweighs the disadvantage from more expensive capital.

During the late 1990s, the global economy witnessed a string of major currency devaluations and financial crises in Asia, South Africa, Russia, and Brazil. In Cheap Labor Meets Costly Capital: The Impact of Devaluations on Commodity Firms (NBER Working Paper No. 9053), author Kristin Forbes examines how such devaluations affected costs, production decisions, and profitability for commodity-producing companies within the devaluing countries and for their foreign competitors. She concludes that although devaluations in the short run help domestic producers boost profits and output vis-à-vis the rest of the world, their long-term impact is more ambiguous and depends on the firms' relative dependence on capital and labor. These conclusions run counter to the conventional notion that devaluations reduce the cost of exports in international markets and therefore boost exports from the devaluing country.

Forbes first considers the case of firms in a small, open economy with competing firms in the rest of the world. Labor is priced in the domestic currency, while capital is priced in dollars. After a devaluation, the relative cost of labor declines in the crisis country, so firms there are able to increase output and profits. In the long term, however, the devaluation increases the cost of capital for firms in the crisis country, possibly by more than the exchange-rate movement, if there is an increase in domestic risk or if interest rates rise. If the firm has a high enough capital/labor ratio, then the increased cost of capital could outweigh any benefit from the cheaper labor.

For competing firms in the rest of the world, analysis predicts the opposite results. In the short run, output and profits decline. Depending on the use of capital and labor by foreign firms, however, the devaluation could increase their output, profits, and investment in the long run.

Next Forbes gathers data for 1,100 firms around the world across ten commodity industries, including natural rubber and forest products, mining, natural gas and crude petroleum, fruits and vegetables, edible oils and fats, cigarettes, industrial chemicals, plastics, materials and synthetics, and fertilizers. The data include firms from eight countries that experienced "major devaluations" -- defined as cases in which the local currency depreciates against the U.S. dollar by 15 percent or more within any four-week period -- from January 1997 through December 1999.

Forbes's results show that, immediately following devaluations, firms in the crisis countries expanded their output by an average of 21 percent, compared to output growth of 8 percent in non-devaluing countries. Profits following devaluations followed a similar pattern, growing by 23 percent in devaluing countries versus 8 percent in non-devaluing nations. For example, among edible oils and fats firms, production and profits expanded by 16 percent and 17 percent, respectively, in crisis economies, compared to 4 percent and negative 1 percent in the rest of the world.

Forbes' analysis had predicted that, following a devaluation, firms in the devaluing economy increase capital investment while competing firms abroad reduce capital investment, if two conditions are met: first, if labor's share in output is large compared to capital's share; and second, if the increase in interest rates is small in the devaluing country. In other words, the impact on capital investment depends on the firms' capital/labor ratio and on the price of capital.

Here the data also tend to support her predictions. Forbes divides the sample of firms from crisis countries into two groups, based on whether their capital/labor ratio exceeds the mean ratio for all firms in devaluing countries. Firms with higher ratios have slower capital growth rates than firms with lower capital/labor ratios. The data also reveal that "devaluing country firms with low capital/labor ratios and no significant increase in interest rates had the highest investment growth (15 percent), while firms with high capital/labor ratios and a large increase in interest rates had the slowest investment growth (10 percent)."

Finally, Forbes uses stock price data to assess whether expectations of long-run profits fit her predictions. After devaluations, commodity-exporting firms in the devaluing countries should have higher long-run profits than competing foreign firms if, again, labor's share in output is large relative to capital and the increase in the cost of capital is low. Forbes examines the average 3-month return starting in the month prior to the devaluation and ending in the month following the devaluation, and finds that firms with higher capital/labor ratios showed an average return of negative 34 percent, while the return for companies with lower ratios was negative 21 percent. "Although the majority of firms experienced negative returns during this period," Forbes writes, "these statistics suggest that investors expected profits for more labor-intensive firms to be less adversely affected by the devaluations than the profits of more capital-intensive firms."

Similarly, firms with lower capital/labor ratios and that did not experience a large interest rate increase showed the best 3-month average stock performance (negative 6 percent), while firms with higher capital/labor ratios and high interest rate increases displayed the worst performance (negative 29 percent).

Ultimately, Forbes concludes that a key factor determining whether crisis-country firms benefit from devaluations is whether the cost advantage from cheaper labor outweighs the disadvantage from more expensive capital. "The results could provide important insights on why some devaluations boost exports, improve economic growth, and spread to other countries," explains Forbes, "while other devaluations have little effect on the trade balance, are contractionary, and have minimal impact on the rest of the world."

-- Carlos Lozada