Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment

34 Pages Posted: 19 Jul 2000 Last revised: 17 Oct 2022

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: July 2000

Abstract

While there is still much disagreement on the causes underlying recent emerging markets' crises, one factor that most observers have agreed upon is that contracting dollar' (foreign currency) denominated external debt as opposed to domestic currency debt created balance sheet mismatches that led to bankruptcies and dislocations that amplified downturns. Much of the analysis of the currency-balance sheet channel' hinges on the assumption that companies contract dollar denominated debt. Yet there has been little systematic inquiry into why companies must or choose to take on dollar debt. In this paper we cast the problem as one of microeconomic underinsurance with respect to country-wide aggregate shocks. Denominating external debt in domestic currency is equivalent to contracting the same amount of dollar-debt, complemented with insurance against shocks that depreciate the equilibrium exchange rate. The presence of country-level international financial constraints justify the purchase of such insurance even if all agents are risk neutral. However, if domestic financial constraints also exist, domestics will undervalue the social contribution of contracting insurance against country-wide shocks. Foreign lenders will reinforce the underinsurance problem by reducing their participation in domestic financial markets.

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment (July 2000). NBER Working Paper No. w7792, Available at SSRN: https://ssrn.com/abstract=236659

Ricardo J. Caballero (Contact Author)

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