Dollarization of liabilities : underinsurance and domestic financial underdevelopment PDF
Preview Dollarization of liabilities : underinsurance and domestic financial underdevelopment
LIBRARIES qfTE^V, HB31 .M415 Massachusetts Institute of Technology Department of Economics Working Paper Series DOLLARIZATION OF LIABILITIES: UNDERINSURANCE AND DOMESTIC FINANCIAL UNDERDEVELOPMENT Ricardo Caballero, MIT Dept ofEconomics J. Arvind Krishnamurthy, Northwestern University Working Paper 00-14 July 2000 Room E52-251 50 Memorial Drive MA Cambridge, 02142 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http //papers ssrn com/paper taf?abstract_id=XXXXXX : . . . MASSACHUSETTS INSTITUTE OFTECHNOLOGY LIBRARIES Massachusetts Institute of Technology Department of Economics Working Paper Series DOLLARIZATION OF LIABILITIES: UNDERINSURANCE AND DOMESTIC FINANCIAL UNDERDEVELOPMENT Ricardo Caballero, MIT Dept of Economics J. Arvind Krishnamurthy, Northwestern University Working Paper 00-14 July 2000 Room E52-251 50 Memorial Drive MA Cambridge, 02142 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://papers.ssrn.com/paper.taf?abstract_id=XXXXXX — Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment Ricardo J. Caballero Arvind Krishnamurthy* June 27, 2000 Abstract Whilethereisstillmuchdisagreement on the causes underlying recent emerging mar- kets' crises, one factorthat most observers have agreed upon is that contracting "dollar" — (foreigncurrency) denominated external debt asopposedto domestic currency debt created balance sheet mismatches that led to bankruptcies and dislocations that ampli- fied downturns. Much ofthe analysis ofthe "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 ofdollar-debt, complemented with insurance against shocks that depreciate the equilibrium exchange rate. The presence ofcountry- level international financial constraintsjustify the purchase ofsuch insurance even ifall 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. JEL Classification Numbers: F300, F310, F340, G150, G380 Keywords: Currency mismatch, balance sheets, financial constraints, international liquidity, insurance, contingent credit lines, put options, capital flows, thin markets, limited participation. 'Respectively: MIT and NBER; Northwestern University. We thank Adriano Rampini for useful discus- sions. Caballero thanksthe NSF for financialsupport. E-mails: [email protected], [email protected]. Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium Member Libraries http://www.archive.org/details/dollarizationoflOOcaba
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