ArticlePDF Available


This paper analyzes the interplay between individual borrowers' choices for liability denomination and the optimal monetary policy. If the monetary authority cares about preventing bankruptcy and most liabilities are denominated in dollars, it will stabilize the exchange rate at the expense of higher volatility in the interest rate and vice-versa if most liabilities are denominated in local currency. That can generate multiplicity of equilibria in the liability composition. If an individual borrower expects the others to borrow in dollars (pesos) he or she will expect the monetary policy to be tailored for that liability denomina-tion and as a result would find it optimal to borrow in dollars (pesos) as well. If the monetary authority has a strong enough preference for exchange rate (interest rate) stability the equilibrium becomes unique with the liabilities denominated in dollars (pesos).
Marcos Chamon
Harvard University, Dept.of Economics Ph.D. Candidate
Ricardo Hausmann
Harvard University, Kennedy School of Government
First Draft: July 2002. This Version: November 2002.
This paper analyzes the interplay between individual borrowers’
choices for liability denomination and the optimal monetary policy. If
the monetary authority cares about preventing bankruptcy and most
liabilities are denominated in dollars, it will stabilize the exchange rate
at the expense of higher volatility in the interest rate and vice-versa if
most liabilities are denominated in local currency. That can generate
multiplicity of equilibria in the liability composition. If an individual
borrower expects the others to borrow in dollars (pesos) he or she will
expect the monetary policy to be tailored for that liability denomina-
tion and as a result would nd it optimal to borrow in dollars (pesos)
as well. If the monetary authority has a strong enough preference for
exchange rate (interest rate) stability the equilibrium becomes unique
with the liabilities denominated in dollars (pesos).
The authors are grateful to Roberto Chang, Federico Sturzenegger and seminar par-
ticipants at the Original Sin Pre-Conference and Lacea 2002 for helpful comments. Any
errors are ours.
1 Introduction
Why do companies and households in many emerging markets borrow in
foreign currency? After all, the recent spate of crises in which liability “dol-
larization” has interacted with drastic real depreciations to create massive
bankruptcies and economic havoc suggests that it is an important source of
nancial fragility. But what causes this phenomenon? Is it that they do not
want to borrow in domestic currency because their choices are distorted by
moral hazard, or is it that, for other reasons the domestic currency market
does not exist, especially for international lending? A signicant part of the
literature has been focused on moral hazard interpretations. If companies ex-
pect to be bailed out by governments, they will not fully internalize the risks
they bear (Dooley (2000), Burnside, Eichenbaum and Rebelo(2002), Schnei-
der and Tornell (2000). But the telltale signs moral hazard in terms of the
pattern of lending have not found much empirical support (Eichengreen and
Hausmann (1999), Fernandez-Arias and Hausmann (2000). A more recent
literature has proposed other models. Caballero and Krishnamurthy (2002)
present a model where excessive dollar debt is the result of domestic nancial
constraints that lead rms to undervalue the social benet of borrowing in
local currency. Jeanne (2002) argues that liability dollarization can be a safe
play when low monetary credibility keeps interest rates in domestic currency
high. Chamon (2001) and Aghion, Bacchetta and Banerjee (2001) present a
model where the correlation of devaluation risk and default risk makes do-
mestic currency lending unattractive. In their setup, it is possible for a rm
to expropriate the claim that domestic currency creditors have on the resid-
ual value of the bankrupt company by increasing their borrowing in foreign
currency, given that in the context of a bankruptcy, the claims of domestic
currency creditors will be automatically written down by the concomitant
depreciation. In anticipation of this, investors refrain from lending in domes-
tic currency. Tirole (2002) proposes a “dual-and-common agency” approach
to the problem, where a foreign investor’s return depends not only on the
behavior of a private borrower but also on that of the borrower’s government
with whom he does not contract.
In this paper we explore the interplay between individual borrower’s
choices for liability denomination and the optimal monetary response of the
Central Bank given those choices. We start from the assumption that the
debt in domestic currency cannot be contracted at long maturities and at
xed rates. As a result, the terms in which it is rolled over or repriced will
depend on changes in the domestic interest rate. In the model presented,
there is a shock to the expected future exchange rate. Since agent’s are for-
ward looking, that shock aects the present interest and exchange rates. The
Central Bank uses monetary policy so as to determine how the absorption of
that shock is divided between changes in the interest rate and in the exchange
rate. If most liabilities are dollarized and the Central Bank cares about pre-
venting bankruptcy, it will stabilize the exchange rate at the expense of larger
movements in the interest rate. Alternatively, if most liabilities are denomi-
nated in pesos the Central Bank will stabilize the interest rate at the expense
of larger movements in the exchange rate. This can generate multiplicity of
equilibria in the liability composition, since if an atomistic agent expects all
other agents to denominate their debt in dollars (pesos) he or she will expect
the monetary policy to be tailored for that particular liability denomination
and as a result may nd it optimal to borrow in dollars (pesos) as well. It
is worth noting that the policy maker in our model does not attempt to ex-
propriate foreign investors to the benetofdomesticresidentsasinTirole
(2002). Instead, it is only trying to make dollar debt safer given that those
contracts have already been written.
The interaction of liability denomination and monetary policy has re-
ceived recent attention. Calvo and Reinhart (2000) and Hausmann, Panizza
and Stein (2001) show that emerging markets that formally oat their cur-
rency tend to limit the movement of the exchange rate vis a vis the interest
rate and to accumulate signicantly larger stocks of international reserves.
Hausmann et al show that this behavior is strongly correlated with measures
of the ability of a country to borrow internationally in its own currency.
Hence, the title of their paper “Why do countries oat the way they oat?”
receives implicitly the answer “because they borrow the way they borrow”.
There is also a recent literature relating the structure of liabilities to the
choice of monetary policy. Aghion, Banerjee and Bacchetta (2001) show
how balance sheet eects can make devaluations contractionary and opti-
mal monetary policy apparently pro-cyclical. Cespedes, Chang and Velasco
(2000) present a model where the eectiveness of monetary policy although
still positive is signicantly compromised in its ability to dampen cyclical
uctuations by the presence of liability dollarization. These works focus on
how liability dollarization can aect the optimal monetary policy. There is
also a literature that studies how monetary policy can aect the currency
composition of corporate debt (for example, Jeanne 2000). In this paper,
we emphasize how the choice of an individual entrepreneur’s liability com-
position can be aected by the choice of the other entrepreneurs through the
eect of their choice on the resulting monetary policy.
2 The basic environment
Consider a small open economy subject to shocks to its expected future
exchange rate. These shocks are assumed to be out of the control of the
economy’s policy maker (for example terms of trade shocks) and are not
modeled explicitly. We assume the resulting exchange rate expectations are
distributed according to a random variable zt.
The focus of the model is on a small segment of the nontradable sector
which consists of atomistic entrepreneurs. Those entrepreneurs have access
to a production function that requires an initial investment of one unit of
the local currency (henceforth pesos) and whose output is worth Apesos.
Two types of debt are considered. The rst, which we refer to as dollar debt
is denominated in the foreign currency. The second type which we refer to
as peso contracts are denominated in the home local currency. We assume
one cannot write peso contracts in terms of a xed domestic interest rate.
Instead, peso debt contracts must pay the ex post domestic interest rate for
the period the loan was made. This assumption aims at capturing the fact
that in practice the maturities of local currency contracts are much smaller
than those of foreign currency ones in emerging markets, and that by bor-
rowing through short-term local currency debt the borrowers are vulnerable
to shocks to the interest rate at which that debt is rolled over.
The debt contracts must be written in the beginning of time twhen the
exchange rate is given by e0
t. The expectation at time tfor the exchange rate
in period t+1 is given by the random variable ztwhose realization occurs
at the beginning of period t, but only after the debt contracts have been
written. The higher zt, the larger the expected depreciation (which can be
interpreted as the result of an adverse shock). Thus, the expected exchange
rate in period t+1 at the beginning of period tis given by E0
and is updated to Et[et+1 ]=ztfollowing the realization of that uncertainty.
The monetary authority decides how to accommodate the shock ztE[zt]
between changes in the interest rate and in the exchange rate.We assume an
uncovered interest parity condition must be satised:
where itis the domestic risk-free rate, ithe constant world interest rate and
The value of e0
tis given by arbitrage between peso and dollar instruments at
the beginning of time t:
t[1 + it]=(1+i)E0
We assume that entrepreneurs are risk-neutral, but face a non-pecuniary
cost associated with defaults. As a result, when deciding whether to borrow
in pesos or dollars they seek to minimize the probability of a default occur-
ring. An entrepreneur that has borrowed through peso debt, paying a risk
premium rpeso defaults if:
A<(1 + it)(1 + rpeso)(2)
while an entrepreneur that borrowed through dollar debt paying a risk pre-
mium r$defaults if:
A<(1 + i)(1 + r$)et/e0
In principle an entrepreneur could mix the two denominations, but we
show that this is not optimal in this model.
1. Debt contracts are written
2. Theshocktotheexpectationofthenextperiodexchangerateis
3. Given that shock and the currency composition of the debt contracts,
the monetary authority sets itand et.
The monetary authority (henceforth the Central Bank) takes that cost of
default into account when choosing itand et.It also seeks to minimize the
gap between the economy’s output and an ideal target and to minimize the
ination rate. Output and ination are a function of the interest rate and
of the exchange rate, given by the equations below where a sans-serif font
indicates a variable is expressed in log terms:
where ytis the log of the output, πtthe ination rate, yand πare constants,
and α,β,γand λare positive constants. Since the entrepreneurial sector
that borrows from abroad is assumed to be small, the eect of its liability
composition on these parameters is ignored. The Central Bank’s ination
versus output trade-ois given by the loss function:
where e
yis the log of the ideal output target and χis a constant.In addition
to that trade-obetween output and ination, the Central Bank’s welfare
function is also aected by the share of entrepreneurs that would default
given its choice for itand et. The Central Bank’s loss function taking this
eect in consideration is given by:
where s(it,e
t)is the share of bankrupt entrepreneurs given the monetary
policy and Cis the cost of that default to the Central Bank’s welfare. That
cost diers from the private one incurred by the entrepreneurs depending on
the extent to which the Central Bank internalizes their welfare and on the
externalities that their bankruptcy can impose on the rest of the economy.
It is useful to initially consider the case where the Central Bank does not
take into account those entrepreneurs when setting its monetary policy (i.e.
C=0). The Central Bank’s loss function becomes L=`. Minimizing (4)
subject to (1) yields the following policy rules:
it=iψ+(1 ζ)zt(7)
and 0<ζ<1. Thus, the Central Bank accommodates the shock in a
way that both the elasticities of itand etwith respect to ztare positive but
smaller than one and together they add to unity.
Consider the case where parameters are such that ζ=1/2(i.e. the
Central Bank distributes the shock to ztbetween itand etwith the same
elasticity). We solve the recursive equilibrium and show that if everyone
else borrows in dollars, an atomistic entrepreneur is better oborrowing in
dollars as well since the monetary authority will stabilize the exchange rate
at the expense of higher volatility in the interest rate. The opposite is true
if everyone were to borrow in pesos.
Suppose that in the rststageofthegameallentrepreneurschooseto
borrow in dollars. The monetary authority knows that in order to prevent a
default from occurring, it must set etbelow a critical level ec
tgiven by:
(1 + i)(1 + r$)
There are three regions of interest for the problem solved by the monetary
authority in stage 3:
Region 1: The condition etec
tis not binding:
In this region, the realization of ztis such that the monetary authority
does not need to worry about defaults occurring. As a result, it sets etand
itaccording to (6) and (7):
In this region both etand itincrease on the square root of zt.
Region 2: The realization of ztis such that the Central Bank chooses to
set et=ec
tin order to avoid defaults and accommodates the remaining part
of the shock through it.
In this region the Central Bank sets:
Note that instead of increasing on the square root of zt,itis linear on zt
in this range.
Region 3: The realization of ztis so large that the Central Bank gives up
accommodating the change in etand lets the entrepreneurs go bankrupt:
The Central Bank decides to “throw in the towel” if the interest rate hike
necessary to keep the exchange rate at ec
tis so high that the loss function
is actually larger than the one where it lets them go bankrupt and accom-
modates the shock between the two instruments. The Central Bank’s loss
function given a realization of ztwhen ignoring bankruptcy issues can be
dened as a function of et.Thedierence between the value of that function
obtained by setting et=ec
tas opposed to the level ψ+1
2ztit would choose
in the absence of bankruptcy considerations is obtained by taking a Taylor-
series expansion1:
+`00 ¡ψ+1
=`00 ¡ψ+1
>Cfor large enough zt(14)
The above expression is increasing on the dierence between ec
tand ¡ψ+1
Thus, for large enough ztthat loss will dominate the one associated with the
cost Cof letting the entrepreneurs go bankrupt. Once that level is reached,
the Central Bank’s response is given by (10) and (11). Note that there is
a discontinuity around that critical value of ztwithadiscreteincreaseinet
and a discrete decline in it.
So far, we have shown that given dollarization of liabilities the Central
Bank will “oat with a life-jacket”, letting the exchange rate oat over some
range but aggressively intervening if a certain threshold is reached. But for
ahighenoughrealizationofztit will give up on that intervention and let
it oat again. It remains to show that given that the Central Bank will act
this way, agents would indeed prefer to borrow in dollars.
Since the entrepreneurs are risk neutral, when choosing the composition
of their liabilities they only care about which of them decreases the likelihood
of a default.
Let zc
$and zc
peso denote the critical values of the realization of the zt
above for which an entrepreneur would default given dollar and peso liabilities
Since from arbitrage both types of liabilities must yield the same expected
1Note that since `(et)is quadratic, `(n)(et)=0for n>2.
return to the lenders, we have:
(1 + i)(1 + r$)et
Pr(z)dz =Zzc
(1 + rpeso)(1 + it)Pr(z)dz (15)
where both etand itare increasing functions of z,andtheriskpremiumsr$
and rpeso are decreasing on zc
$and zc
peso. Arbitrage between risk-free short-
term peso and dollar instruments implies:
(1 + i)et
Pr(z)dz =Zz
(1 + it)Pr(z)dz (16)
The solution of the Central Bank’s problem implies that there exists zA
and zBsuch that zA>z
2(zAzB)it(zA)it(zB),with strict inequalities for some zB
Proposition 1 zc
Proof. Suppose zc
Equation (16) can be rewritten as:
(1 + i)
etPr(z)dz +Zz
(1 + it)Pr(z)dz +Zz
(1 + it)Pr(z)dz
The equation above and inequality (17) imply:
(1 + i)
etPr(z)dz < Zzc
(1 + it)Pr(z)dz
which implies
(1 + i)
(1 + rpeso)etPr(z)dz =Zzc
(1 + rpeso)(1 + it)Pr(z)dz
for some z0>z
peso.That implies r$<r
peso, which in turn implies zc
a contradiction.
Thus if all other entrepreneurs borrow in dollars the resulting monetary
policy is such that dollar debt is safer. Note that since etand itare perfectly
correlated in the range where dollar debt holders would default, there are
no benets from mixing the two debt denominations (unless the borrowers
could short the peso instrument which we do not allow in our analysis).
The problem presented is completely symmetric between etand it.Asa
result, if all liabilities were in short-term pesos the resulting monetary policy
would be such that short-term peso instruments would be safer2.There-
fore, if an atomistic agent expects all others to borrow through dollar (peso)
debt, he or she will choose to borrow through dollar (peso) debt as well and
multiplicity of equilibria in the debt composition occurs.
3 Preference towards exchange rate or inter-
est rate adjustment
The previous section focused on the case where the elasticities of the ex-
change rate and the interest rate with respect to ztwere the same. But if
parameters are such that the resulting optimal monetary policy exhibits a
strong preference towards exchange rate or interest rate stability, the prob-
lem changes quite signicantly. While for some range of parameters there is
still multiplicity of equilibria, welfare is higher in the equilibrium where rms
choose to borrow in the instrument whose return the central bank is trying to
stabilize. Hence, if the Central Bank is more concerned with exchange rate
stability, social welfare is higher if entrepreneurs borrow in dollars. Some
ability to coordinate would allow them to choose the better equilibrium.
This ability may be provided either by a few large borrowers or by the scal
authority. If the government were to denominate its debt so at to minimize
the risk of debt service to the scal accounts, it would choose dollar debts
and rms would just follow suit. Moreover, once a large enough asymmetry
is introduced, there is a unique equilibrium for the debt composition.
2In theory there could be a third equilibrium where half the liabilities are denominated
in dollars and half in pesos. The Central Bank would not be able to help both groups of
creditors, and would randomize which group to help. But that equilibrium is not robust
to small perturbations since if one agent was to switch from peso to dollar debt, every
agent would prefer to borrow only through dollars and vice-versa.
Recall equation (9) which denes the elasticity ζof the exchange rate
with respect to ztaccording to the parameters that determine the eects
of the exchange rate and of the interest rate in the output and ination
of that economy (in the region where the Central Bank ignores bankruptcy
considerations). If ζis small, most of the shock will tend to be accommo-
dated through changes in the interest rates. That elasticity is small when
the expansionary eect of exchange rates on output is low (αis small), the
exchange rate pass-through to ination is high (γis large) and interest rates
have little impact on aggregate demand and ination (βand δare small).
These assumptions seem particularly relevant to emerging markets. Because
of that we focus on the case where ζis small. But just like in the previous
section, the actual realizations of etand itare inuenced by the composition
of debt liabilities.
Figure 2 illustrates the case where ζis small and liabilities are denomi-
natedindollars. Therangeofztin which a default occurs is smaller than in
the basic scenario of the previous section since the Central Bank is now more
willing to stabilize etat the expense of it. But if liabilities are denominated
in pesos, the Central Bank’s greater willingness to stabilize the exchange
rate will conict with its willingness to prevent bankruptcy. That case is
illustrated in Figure 3. For some range of ztthe Central Bank will refrain
from raising itbeyond a certain threshold in order not to bankrupt the en-
trepreneurs, accommodating the rest of the shock through the exchange rate.
In that range itis held constant while etincreases linearly in zt. But just like
in the analysis of the previous section, this deviation from the Central Bank’s
ideal rule for accommodating the shock becomes too costly for a large enough
realization of zt. Beyond that critical point, the Central Bank gives up trying
to save the entrepreneurs and is again willing to stabilize the exchange rate
at the expense of larger movements in the interest rate. Therefore the set
of values of ztfor which a default under dollar debt occurs can be disjoint
since etis not monotonic in zt. For example, if an entrepreneur borrows in
dollars she may be bankrupt for a given realization zAif that realization lies
in order to keep interest rates low. But she may be solvent for realizations
Aif zBis in the range where the Central Bank would have given up
trying to save the peso borrowers and e(zB)<e(zA).Whether or not the
resulting distributions of etand itcan sustain an equilibrium where the debt
is denominated in pesos depends on parameter values. If the costs of default
are low (or if they are high but the Central Bank does not internalize them
much) or if the Central Bank is much more concerned about etthan about it,
then one would prefer to borrow in dollars even if everyone else were to bor-
row in pesos. As a result, there would only be a single equilibrium where all
debt is denominated in dollars. But again, if parameters are such that multi-
plicity of equilibria still occur, welfare is higher in the equilibrium where the
debt is denominated in the instrument whose movements the Central Bank
would rather stabilize. It seems reasonable to assume that if large players
are involved (such as the government), the economy will eventually manage
to coordinate on the preferred of the two equilibrium.
4 Discussion
The model presented in this paper argues that the interplay between indi-
vidual borrower’s choices for liability composition and the optimal monetary
policy can lead to an outcome where liability dollarization is widespread.
That result was obtained under a policy maker that is fairly benign towards
foreign investors in the sense that it is not attempting to expropriate them
to the benet of domestic borrowers. Instead, all that policy maker is trying
to do is to make dollar debt safer given that those contracts have already
been written.
While the model presented only predicts corner solutions, a richer model
with dierent types of shocks is likely to generate equilibria with internal
solutions for the share of dollarized liabilities (with that share depending on
how the monetary policy responds to dierent shocks). The preferences of
the central bank towards exchange rate or interest rate adjustments can play
averysignicant role in terms of focusing the market on a type of borrowing
and of monetary policy. In this sense, countries that exhibit original sin are
countries where the central bank cares more about exchange rate movements
than about interest rate movements. This is often the case in emerging mar-
kets, which can be explained by a number of reasons. In those countries, the
exchange rate pass-through into prices tends to be higher than in developed
ones, and the evidence for devaluations being expansionary is at best mixed.
Moreover, a low level of nancial development weakens the link between in-
terest rates and aggregate demand, and as a result domestic interest rates
have a lower impact on ination and employment. All these elements will
bias the choice towards more stable exchange rates at the expense of higher
volatility in interest rates. Finally, emerging markets have more imperfect
and incomplete nancial markets, so the costs of bankruptcy are likely to be
larger. As a result, that bias towards exchange rate stability is amplied,
with the monetary authority being more willing to use interest rates aggres-
sively in order to stabilize the exchange rate in the presence of dollarized
liabilities. In fact, the volatility of interest rates tends to be much higher in
emerging markets than in developed economies.3
Why countries borrow the way they borrow? Why do countries dier in
their borrowing behavior? The most likely candidates would be countries
where the central bank has a preference for exchange rate stability and that
suer from high volatility and bankruptcy costs.
Finally, while the model has focused on the borrower’s choice for liability
denomination, some of the insights can shed light into the related problem
of denomination of savings. If households are risk averse and their income
is not correlated with the shock to the expected future exchange rate, then
they would rather just save in whatever instrument makes the value of their
savings more stable. For example, if the debt composition is such that the
Central Bank stabilizes the exchange rate at the expense of the interest rate
and the parameters are such that the resulting distribution of peso savings is
riskier than that of dollar ones, the households would rather save in dollars.
If however, the realization of the shock to the expected future exchange rate
is correlated with household income (if for example it reects productivity
shocks that aect the marginal product of labor and as a result the house-
hold’s labor income) then matters become more complicated. On the one
hand households dislike uncertainty on the return to their savings. But on
the other hand they want that return to covary negatively with their labor
income. As a result, they will be willing to hold some peso denominated
instruments, since those instruments do better than dollar denominated ones
over some range of “bad” realizations of the shock4. The share of their sav-
ings held in peso instruments will depend on the distribution of returns and
3Hausmann (2002) estimates the volatility of changes in 12-month real interest rates
in a sample of Latin American countries in the period 1994-1999. Using a sample that
excludes observations when ination exceeded 40% the average volatility was 10.5%, while
the corresponding gure for the United States was only .9%
4The Central Bank will give up trying to stabilize the exchange rate for very bad
realizations of the shock, and dollar savings would provide higher returns than peso ones
in those states. But for intermediate levels of a bad shock, the exchange rate is stabilized
at the expense of an interest rate hike and peso savings will have a larger return than
dollar ones.
on how that shock to the expected future exchange rate covaries with their
Figure 1: Exchange rate and interest rate if ζ=1/2and liabilities are
denominated in dollars.
Figure 2: Exchange rate and interest rate if ζis small and liabilities are
denominated in dollars.
Figure 3: Exchange rate and interest rate if ζis small and liabilities are
denominated in pesos.
[1] Aghion, P., Bacchetta, P. and A. Banerjee (2001). “A Corporate
Balance-Sheet Approach to Currency Crises,” mimeo.
[2] Burnside, C., M. Eichenbaum, and S. Rebelo (2002). “Prospective
Decits and the Asian Currency Crises”. Journal of Political Economy.
Fort h comi ng.
[3] Caballero, R. and A. Krishnamurthy (2002). “Excessive Dollar Debt:
Financial Development and Underinsurance” Journal of Finance,forth-
[4] Calvo, G. and C. Reinhart (2002). “Fear of Floating,” Quarterly Journal
of Economics Vol. 113(3), pp. 379-48.
[5] Cespedes, L., R. Chang and A. Velasco (2000). “Balance Sheets and
Exchange Rate Policy,” NBER Working Paper No. 7840, August.
[6] Chamon, M (2001). “Why can’t developing countries borrow from
abroad in their currency?” mimeo, Harvard University.
[7] Dooley, M. (2000). “A Model of Crises in Emerging Markets”. The Eco-
nomic Journal, Vol. 110, no. 460, pp. 256-272.
[8] Eichengreen, B. and R. Hausmann (1999). “Exchange Rates and Finan-
cial Fragility,” NBER Working Paper 7418, November.
[9] Fernández-Arias, E. and R. Hausmann (2000). “What’s Wrong with In-
ternational Financial Markets?” IADB Working Paper No. 429, August.
[10] Jeanne, O. (2001) “Why Do Emerging Markets Borrow in Foreign Cur-
[11] Jeanne, O. (2000) “Foreign Currency Debt and the Global Financial
Architecture,” European Economic Review 44, 719-727.
[12] Hausmann, R. (2002). “Unrewarded Good Fiscal Behavior: The Role of
Debt Structure,” mimeo, Harvard University.
[13] Hausmann, R., Panizza, U., and E. Stein (2001). “Why Do Countries
Float the Way They Float” Journal Of Development Economics (66)2
pp. 387-414.
[14] Schneider, M. and A. Tornell (2000). “Balance SHeet Eects, Bailout
Guarantees and Financial Crises,” NBER Working Paper No. 8060, De-
[15] Tirole, J. (2002). “Inecient Foreign Borrowing: A Dual-and Common-
Agency Perspective,” CERAS, mimeo.
... The controversy is that a peg may not be a good solution because fixed exchange rates create moral hazard and lead to excessive foreign currency borrowing (Burnside et al. 2001). Moreover, since a fixed exchange rate is generally achieved at the expense of a stable interest rate, risk-averse borrowers and lenders would then prefer to use foreign currency debt denomination even in the absence of the moral hazard problem (Chamon and Hausmann 2002). Lee (2022) finds empirically that emerging market sovereigns borrow even more in foreign currency when exchange rate volatility is higher, precisely when it is riskier for them to do so. ...
... Consequently, emerging economies suffering from the original sin problem face a major dilemma: On the one hand, a fixed exchange regime in open international capital markets is an accident waiting to happen because of the high-interest rate variability and the maturity mismatch problem. On the other hand, a floating exchange regime is counterproductive since banks and firms will suffer the currency mismatch problem (Eichengreen and Hausmann 1999;Chamon and Hausmann 2002). Excessive external borrowing can equally cause the overinvestment problem when domestic savings are already very high (Jonas 2003). ...
Full-text available
Unlabelled: Over the last decade (2010-2020), Tunisia foreign debt has experienced a phenomenal jump. It has increased at a faster pace than domestic debt. It has doubled without any significant positive effect on investments or economic growth. This study aims to identify the major causes of this abnormal increase in Tunisia foreign debt. Since the model variables are not all stationary at level, the paper applies the autoregressive distributed lag technique to quantitative quarterly economic data covering the 2009-2020 period. Findings show that the economic growth, the exchange rate, the current deficit, the coverage ratio, and the lagged foreign debt itself are the major causes leading to the phenomenal increase of Tunisia foreign debt. Based on these findings, the paper suggests boosting foreign currency-generating activities, containing current public expenditures, stabilizing the exchange rate, and making structural economic adjustments as possible escape roots. Supplementary information: The online version contains supplementary material available at 10.1007/s43546-023-00443-2.
... Each household decides his consumption, domestic nominal bond purchase, and labor supply every period. The household derives income from wages, profits from export firms, 14 The aggregate labor service hired by an export or non-traded goods firm can be defined as ...
... and13 This structure has been adopted by many papers in the open-economy literature. For instance, see Obstfeld14 As the non-traded sector is perfectly competitive, the profit from this sector is zero. returns on domestic bond holding. ...
... Our discussion is close in spirit to that in Chamon and Hausmann (2002). In that paper, if domestic Þrms have large dollar liabilities, unexpected changes in the real exchange rate can drive the Þrms into costly bankruptcy. ...
Some important events and trends in recent years have intensified concerns about FD. First, there is mounting evidence that FD has increased or remained stable despite declining inflation rates. Second, dollarization has greatly complicated the policy response in several crises and near-crisis episodes and, in some cases, has been singled out as the source of financial vulnerability that triggered a crisis. Third, the widespread shift from fixed to more flexible exchange rate regimes has altered the policy landscape, highlighting the prudential consequences of exchange rate risk. As a result, the policy debate about de-dollarization has heated up. Is de-dollarization a realistic goal? Is it worth the trouble? If so, how can it be pursued? Guided by these questions, this chapter tries to summarize where we stand on what remains a continuing debate.
Full-text available
Developing countries in the past, experienced many economic crises that usually caused by large amounts of external debt. Accordingly, interest on the debt in these countries focused on external borrowing. However, in developing countries, since the mid-1990s, due to increased domestic public debt interest is shifting to domestic borrowing. In this study, using the data of 17 selected developing economies for the period of 1980-2010, the development of domestic debt stock is analyzed and economic dynamics of the domestic public stock is is tested with the methodology of panel data analysis. The analysis indicates that GDP increase the domestic debt, while budget deficit/GDP and inflation rate reduce it.
Full-text available
To update a famous old statistic: a political leader in a developing country is almost twice as likely to lose office in the six months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless of whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last 10 years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Pass-through from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.
This paper examines the case for using two instruments—the policy interest rate and sterilized foreign exchange market intervention—in emerging market countries seeking to stabilize inflation and output while attenuating disequilibrium currency movements. We estimate policy reaction functions for central banks, documenting that indeed both instruments tend to be deployed. We show that whether discretionary monetary policy or inflation targeting is preferable depends on the volatility of shocks relative to the central bank’s time inconsistency problem. The use of FX intervention as a second instrument improves welfare under both regimes, but more so under inflation targeting. Overall, a regime of (two-way) sterilized intervention-cum-inflation targeting can result in better outcomes in the presence of imperfect capital mobility/asset substitutability—yielding similar gains to a discretionary policy but without jeopardizing the inflation target.
Full-text available
This paper argues that the recent Asian currency crisis was caused by large prospective deficits associated with implicit bail out guaranteed to guarantees to failing banking systems. We articulate this view using a simple dynamic general equilibrium model whose key feature is that a speculative attack is inevitable once the present value of future government deficit rises.
Full-text available
This paper explores the hypothesis that the dollarization of liabilities in emerging market economies is the result of a lack of monetary credibility. I present a model in which firms choose the currency composition of their debts so as to minimize their probability of default. Decreasing monetary credibility can induce firms to dollarize their liabilities, even though this makes them vulnerable to a depreciation of the domestic currency. The channel is different from the channel studied in the earlier literature on sovereign debt, and it applies to both private and public debt. The paper presents some empirical evidence and discusses policy implications.
This paper discusses different nviews about what is wrong with the world, or as an economist would say, the principal distortions that are present. The intent is to clarify the logic behing the proposals for reforming the international financial architecture and provide a means of assessing them.
This paper analyzes the different implications of denominating foreign debt in a tradable or in a nontradable good, analogous to foreign currency and a local price index respectively. While the price of tradables is exogenous to a small open economy, the price of nontradables reacts to the shocks it experiences, being high (low) following a good (bad) shock. Since defaults are correlated with large real depreciations, debt denominated in the tradable good will have a relatively higher face-value in those states. If there are large deviations from strict creditor seniority enforcement, a nontradable denominated debt holder's claim on a borrower's bankrupt firm can be expropriated through additional borrowing denominated in the tradable good. This dilution mechanism is an inefficient expropriation technology, whose cost is borne by the borrower in equilibrium. That discourages the use of nontradable denominated instruments, even though they can improve international risk sharing and help prevent financial crises.
Countries that are classified as having floating exchange rate systems (or very wide bands) show strikingly different patterns of behavior. They hold very different levels of international reserves and allow very different volatilities to the movements of the exchange rate relative to the volatility that they tolerate either on the level of reserves or on interest rates. We document these differences and explore potential causes that have been suggested by the recent theoretical literature. In particular, we explore the role of the pass-through of exchange rate movements into prices and the consequences of currency mismatches in balance sheets, which we associate to a country's ability to borrow internationally in its own currency. We find a very strong and robust relationship between the pattern of floating and the ability of a country to borrow internationally in its own currency. We find little evidence of the importance of pass-through to account for differences across countries with respect to their exchange rate/monetary management.
This paper presents a general equilibrium currency crisis model of the ‘third generation’, in which the possibility of currency crises is driven by the interplay between private firms’ credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features (i) ex post deviations from purchasing power parity; (ii) credit constraints a la Bernanke–Gertler; (iii) foreign currency borrowing by domestic firms; (iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. We show that an interest rate increase intended to support the currency in a crisis may not be effective, but that a relaxation of short-term lending facilities can make this policy effective by attenuating the rise in interest rates relevant to firms.
This paper discusses some problems posed by foreign currency debt for emerging economies in the context of the ongoing debate on the reform of the global financial architecture. We present a model in which the currency composition of corporate debt is endogenous, and discuss the optimality of measures aimed at coping with the risks posed by foreign currency debt. While removing these risks is not necessarily efficient in the presence of moral hazard, some forms of public intervention, such as a tax on foreign currency debt or international bailouts, may be optimal.
This paper argues that the recent Southeast Asian currency crises was caused by large prospective deficits associated with implicit bailout guarantees to failing banking systems. We articulate this view using a simple dynamic general equilibrium model whose key feature is that a speculative attack is inevitable once the present value of future government deficits rises. This is true regardless of the government's foreign reserve position or the initial level of its debt. While the government cannot prevent a speculative attack, it can affect its timing. The longer the delay, the higher inflation will be under flexible exchange rates. In our model we present empirical evidence in support of the three key assumptions: (i) that foreign reserves did not play a special role in the timing of the attack; (ii) that large losses in the banking sector were associated with large increases in governments' prospective deficits; and (iii) that the public knew that banks were in trouble before the currency rate crises.