Excessive Dollar Debt: Financial Development and Underinsurance

31 Pages Posted: 19 Apr 2002

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: March 1, 2002

Abstract

We propose that the limited financial development of emerging markets is a significant factor behind the large share of dollar-denominated external debt present in these markets. We show that when financial constraints affect borrowing and lending between domestic agents, agents undervalue insuring against an exchange rate depreciation. Since more of this insurance is present when external debt is denominated in domestic currency rather than in dollars, this result implies that domestic agents choose excessive dollar debt. We also show that limited financial development reduces the incentives for foreign lenders to enter emerging markets. The retarded entry reinforces the underinsurance problems.

Keywords: Currency mismatch, balance sheets, international liquidity, contingent credit lines, thin markets, limited participation

JEL Classification: F300, F310, F340, G150, G380

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, Excessive Dollar Debt: Financial Development and Underinsurance (March 1, 2002). Available at SSRN: https://ssrn.com/abstract=306360 or http://dx.doi.org/10.2139/ssrn.306360

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Arvind Krishnamurthy

Northwestern University - Kellogg School of Management ( email )

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