Dollarization of liabilities : underinsurance and domestic financial underdevelopment

50 Pages·2000·1.7 MB·English

by  Caballero, Ricardo J

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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

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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: [e-mail], [e-mail].
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