Why Can't Developing Countries Borrow from Abroad in Their Currency?

Abstract

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.

Keywords: Financial Indexation, Dollarization, International risk sharing

JEL Classification: F30, F32, F34