Debt Composition and Balance Sheet Effects of Exchange Rate and Interest Rate Volatility in Mexico: A Firm Level Analysis (Second Draft) Ignacio Lobato* Sangeeta Pratap* CIE-ITAM CIE-ITAM Alejandro Somuano** Ministry of Finance May 2003 Abstract In this paper we use Mexican firm-level data to study the role of currency mismatches in exacerbating the negative effects of a devaluation in the corporate sector and to investigate what drives Mexican firms to borrow in foreign currency. Our results show that large firms tend to borrow more heavily in foreign currency. The presence of foreign currency debt poses a significant risk to balance sheets at the time of devaluation. Our findings suggest that in Mexico the balance sheet effects of a devaluation far outweigh the competitiveness effects. * Camino a Santa Teresa 930, México, D.F., 10700. ilobato@itam.mx , pratap@itam.mx. ** Director of Fiscal Policy, Ministry of Finance, Palacio Nacional Patio Central, Mezanine 1010, Col. Centro, México, D.F. 06066, alejandro_somuano@hacienda.gob.mx. We are grateful to Lorenza Martinez for providing the data and to Julio Burciaga for help with data definitions. Marco González and Rodrigo Cuevas provided valuable research assistance.