Cheap Labor Meets Costly Capital: The Impact of Devaluations on Commodity Firms

This paper examines how devaluations affect the relative cost of labor and capital and therefore influence production levels, profitability, investment decisions, and stock returns for firms in the “crisis” country as well as competitors in the rest of the world. The paper develops these ideas in a small, open-economy model and then performs a series of empirical tests using information for about 1,100 firms in 10 commodity industries between 1996 and 2000. The empirical tests support the model’s main predictions. 1) Immediately after devaluations, firms in the crisis country have higher rates of output growth than competitors in other countries; 2) Immediately after devaluations, firms in the crisis country have higher rates of operating-profit growth than competitors in other countries; 3) The effect of devaluations on fixed capital investment and stock returns (and therefore expected long-term output and profits) is determined by capital/labor ratios and changes in the cost of capital. For example, crisis-country firms have higher rates of capital growth and better stock performance after devaluations if they had lower capital/labor ratios and there was no substantial increase in their interest rates. Even though crisiscountry firms may benefit from cheaper labor immediately after devaluations, competitors in other countries may benefit in the long run if firms in the devaluing country used capital intensively and/or their capital becomes more costly. Author contact information: MIT-Sloan School Phone: (617) 253-8996 Room E52-446 Fax: (617) 258-6855 50 Memorial Drive Email: [email protected] Cambridge, MA 02142 Web page: http://web.mit.edu/kjforbes/www *Thanks to Sebastian Edwards and participants at the IASE meetings at the NBER 2000 Summer Institute for helpful comments and suggestions.