Content uploaded by Ricardo Hausmann

Author content

All content in this area was uploaded by Ricardo Hausmann

Content may be subject to copyright.

Whydocountriesborrowthewaythey

borrow?∗

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.

Abstract

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).

∗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.

†chamon@fas.harvard.edu

‡ricardo_hausmann@harvard.edu

1

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

ﬁnancial 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 signiﬁcant 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 ﬁnancial

constraints that lead ﬁrms to undervalue the social beneﬁt 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 ﬁrm

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

ﬁxed rates. As a result, the terms in which it is rolled over or repriced will

2

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 aﬀects 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 ﬁnd 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 beneﬁtofdomesticresidentsasinTirole

(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 ﬂoat their cur-

rency tend to limit the movement of the exchange rate vis a vis the interest

rate and to accumulate signiﬁcantly 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 ﬂoat the way they ﬂoat?”

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 eﬀects can make devaluations contractionary and opti-

mal monetary policy apparently pro-cyclical. Cespedes, Chang and Velasco

(2000) present a model where the eﬀectiveness of monetary policy although

still positive is signiﬁcantly compromised in its ability to dampen cyclical

ﬂuctuations by the presence of liability dollarization. These works focus on

how liability dollarization can aﬀect the optimal monetary policy. There is

also a literature that studies how monetary policy can aﬀect 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-

3

position can be aﬀected by the choice of the other entrepreneurs through the

eﬀect 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 ﬁrst, 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 ﬁxed 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

t[et+1]=E[zt],

and is updated to Et[et+1 ]=ztfollowing the realization of that uncertainty.

The monetary authority decides how to accommodate the shock zt−E[zt]

between changes in the interest rate and in the exchange rate.We assume an

uncovered interest parity condition must be satisﬁed:

1+it=(1+i∗)zt

et

(1)

4

where itis the domestic risk-free rate, i∗the constant world interest rate and

etisthevalueoftheexchangeratefollowingtherealizationofthatshock.

The value of e0

tis given by arbitrage between peso and dollar instruments at

the beginning of time t:

E0

t[1 + it]=(1+i∗)E0

t[et]

e0

t

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

t(3)

In principle an entrepreneur could mix the two denominations, but we

show that this is not optimal in this model.

Thetimingofeventsissummarizedbelow:

1. Debt contracts are written

2. Theshocktotheexpectationofthenextperiodexchangerateis

realized.

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

inﬂation rate. Output and inﬂation 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:

yt=y+αet−βit

πt=π+γet−δit

where ytis the log of the output, πtthe inﬂation rate, yand πare constants,

and α,β,γand λare positive constants. Since the entrepreneurial sector

5

that borrows from abroad is assumed to be small, the eﬀect of its liability

composition on these parameters is ignored. The Central Bank’s inﬂation

versus output trade-oﬀis given by the loss function:

`=(

e

y−yt)2+χπ2

t(4)

where e

yis the log of the ideal output target and χis a constant.In addition

to that trade-oﬀbetween output and inﬂation, the Central Bank’s welfare

function is also aﬀected by the share of entrepreneurs that would default

given its choice for itand et. The Central Bank’s loss function taking this

eﬀect in consideration is given by:

L=`+s(it,e

t)C(5)

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 diﬀers 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:

et=ψ+ζzt(6)

it=i∗−ψ+(1 −ζ)zt(7)

where:

ψ=(α+β)(e

y−y−βi∗)−χ(γ+δ)(π−δi∗)

(α+β)2+χ(γ+δ)2(8)

ζ=(α+β)β+χ(γ+δ)δ

(α+β)2+χ(γ+δ)2(9)

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

6

elasticity). We solve the recursive equilibrium and show that if everyone

else borrows in dollars, an atomistic entrepreneur is better oﬀborrowing 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 ﬁrststageofthegameallentrepreneurschooseto

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:

ec

t=Ae0

t

(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 et≤ec

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):

et=ψ+1

2zt(10)

it=i∗−ψ+1

2zt(11)

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:

et=ec

t

it=i∗+zt−ec

t

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

7

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

deﬁned as a function of et.Thediﬀerence 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:

`(ec

t)−`µψ+1

2zt¶=`0µψ+1

2zt¶µec

t−µψ+1

2zt¶¶

+`00 ¡ψ+1

2zt¢

2µec

t−µψ+1

2zt¶¶2

(12)

=`00 ¡ψ+1

2zt¢

2µec

t−µψ+1

2zt¶¶2

(13)

>Cfor large enough zt(14)

The above expression is increasing on the diﬀerence between ec

tand ¡ψ+1

2zt¢.

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 “ﬂoat with a life-jacket”, letting the exchange rate ﬂoat over some

range but aggressively intervening if a certain threshold is reached. But for

ahighenoughrealizationofztit will give up on that intervention and let

it ﬂoat 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

respectively.

Since from arbitrage both types of liabilities must yield the same expected

1Note that since `(et)is quadratic, `(n)(et)=0for n>2.

8

return to the lenders, we have:

Zzc

$

z

(1 + i∗)(1 + r$)et

e0

t

Pr(z)dz =Zzc

peso

z

(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:

Zz

z

(1 + i∗)et

e0

t

Pr(z)dz =Zz

z

(1 + it)Pr(z)dz (16)

The solution of the Central Bank’s problem implies that there exists zA

and zBsuch that zA>z

c

$>z

Band:

et(zA)−et(zB)≤1

2(zA−zB)≤it(zA)−it(zB),with strict inequalities for some zB

(17)

Proposition 1 zc

$>z

c

peso

Proof. Suppose zc

$≤zc

peso.

Equation (16) can be rewritten as:

(1 + i∗)

e0

tÃZzc

peso

z

etPr(z)dz +Zz

zc

peso

etPr(z)dz!=

Zzc

peso

z

(1 + it)Pr(z)dz +Zz

zc

peso

(1 + it)Pr(z)dz

The equation above and inequality (17) imply:

(1 + i∗)

e0

tZzc

peso

z

etPr(z)dz < Zzc

peso

z

(1 + it)Pr(z)dz

which implies

(1 + i∗)

e0

tZz0

z

(1 + rpeso)etPr(z)dz =Zzc

peso

z

(1 + rpeso)(1 + it)Pr(z)dz

9

for some z0>z

c

peso.That implies r$<r

peso, which in turn implies zc

$>z

c

peso,

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 beneﬁts 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 signiﬁcantly. While for some range of parameters there is

still multiplicity of equilibria, welfare is higher in the equilibrium where ﬁrms

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 ﬁscal

authority. If the government were to denominate its debt so at to minimize

the risk of debt service to the ﬁscal accounts, it would choose dollar debts

and ﬁrms 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.

10

Recall equation (9) which deﬁnes the elasticity ζof the exchange rate

with respect to ztaccording to the parameters that determine the eﬀects

of the exchange rate and of the interest rate in the output and inﬂation

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 eﬀect of exchange rates on output is low (αis small), the

exchange rate pass-through to inﬂation is high (γis large) and interest rates

have little impact on aggregate demand and inﬂation (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 inﬂuenced 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 conﬂict 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

intheregionwheretheCentralBankletstheexchangeratedepreciatemore

in order to keep interest rates low. But she may be solvent for realizations

zB>z

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

11

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 beneﬁt 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 diﬀerent 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 diﬀerent shocks). The preferences of

the central bank towards exchange rate or interest rate adjustments can play

averysigniﬁcant 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 ﬁnancial development weakens the link between in-

terest rates and aggregate demand, and as a result domestic interest rates

have a lower impact on inﬂation 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

12

and incomplete ﬁnancial markets, so the costs of bankruptcy are likely to be

larger. As a result, that bias towards exchange rate stability is ampliﬁed,

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 diﬀer in

their borrowing behavior? The most likely candidates would be countries

where the central bank has a preference for exchange rate stability and that

suﬀer 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 reﬂects productivity

shocks that aﬀect 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 inﬂation exceeded 40% the average volatility was 10.5%, while

the corresponding ﬁgure 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.

13

on how that shock to the expected future exchange rate covaries with their

income.

14

Figure 1: Exchange rate and interest rate if ζ=1/2and liabilities are

denominated in dollars.

0.8

z

0.764

0.779

0.793

z

e

1+i

15

Figure 2: Exchange rate and interest rate if ζis small and liabilities are

denominated in dollars.

0.8

z

0.7625

0.775

0.7875

0.8

0.8125

0.825

0.8375

0.85

0.8625

0.875

0.8875

0.9

0.9125

0.925

0.9375

0.95

0.9625

0.975

0.9875

1

1.0125

1.025

1.0375

1.05

1.0625

1.075

1.0875

1.1

1.1125

1.125

1.1375

1.15

1.1625

z

e

1+i

16

Figure 3: Exchange rate and interest rate if ζis small and liabilities are

denominated in pesos.

0.8

z

0.764

0.779

0.793

0.808

0.822

0.837

0.851

0.866

0.880

0.895

0.909

0.924

0.938

0.953

0.967

0.982

0.996

1.011

1.025

1.04

1.054

1.069

1.083

1.098

1.112

1.127

1.141

1.156

1.170

1.185

1.199

1.214

1.228

1.243

z

e

1+i

17

References

[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

Deﬁcits 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-

coming.

[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-

rency,”mimeo.IMF,Washington,DC.

[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.

18

[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 Eﬀects, Bailout

Guarantees and Financial Crises,” NBER Working Paper No. 8060, De-

cember.

[15] Tirole, J. (2002). “Ineﬃcient Foreign Borrowing: A Dual-and Common-

Agency Perspective,” CERAS, mimeo.

19