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Massachusetts Institute of Technology
Department of Economics
Working Paper Series
DOLLARIZATION OF
LIABILITIES:
UNDERINSURANCE AND DOMESTIC
FINANCIAL UNDERDEVELOPMENT
Ricardo
Caballero,
J.
MIT Dept of Economics
Arvind Krishnamurthy, Northwestern University
Working Paper 00-14
July 2000
Room
E52-251
50 Memorial Drive
Cambridge, MA 02142
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MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
LIBRARIES
Massachusetts Institute of Technology
Department of Economics
Working Paper Series
DOLLARIZATION OF
LIABILITIES:
UNDERINSURANCE AND DOMESTIC
FINANCIAL UNDERDEVELOPMENT
Ricardo
J.
Caballero,
MIT Dept of Economics
Arvind Krishnamurthy, Northwestern University
Working Paper 00-14
July 2000
Room
E52-251
50 Memorial Drive
Cambridge, MA 02142
downloaded without charge from the
Social Science Research Network Paper Collection at
http://papers.ssrn. com/paper. taf?abstract_id=XXXXXX
This paper can be
—
Dollarization of Liabilities:
Underinsurance and Domestic Financial Underdevelopment
Ricardo
J.
Arvind Krishnamurthy*
Caballero
June
27,
2000
Abstract
While there
kets' crises,
much disagreement on
is still
the causes underlying recent emerging mar-
one factor that most observers have agreed upon
(foreign currency)
denominated external debt
is
that contracting "dollar"
—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
this
systematic inquiry into
why companies must
or choose to take on dollar debt. In
paper we cast the problem as one of microeconomic underinsurance with respect
to country-wide aggregate shocks. Denominating external debt in domestic currency
equivalent to contracting the
same amount
of dollar-debt,
against shocks that depreciate the equilibrium exchange rate.
level international financial constraints justify the
agents are risk neutral. However,
will
if
is
complemented with insurance
The presence
of country-
purchase of such insurance even
if all
domestic financial constraints also exist, domestics
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
Numbers: F300, F310, F340, G150, G380
Classification
Keywords:
Currency mismatch, balance sheets, financial constraints, international
liquidity, insurance,
contingent credit
lines,
put options, capital flows, thin markets,
limited participation.
'Respectively:
sions. Caballero
MIT
and NBER; Northwestern University.
thanks the
NSF
We
thank Adriano Rampini
for financial support. E-mails: caball@mit.edu,
for useful discus-
a-krishnamurthy@nwu.edu.
Digitized by the Internet Archive
in
2011 with funding from
Boston Library Consortium
Member
Libraries
http://www.archive.org/details/dollarizationoflOOcaba
Introduction
1
While there
is still
much disagreement on
the causes underlying recent emerging market
one factor that most observers have agreed upon
crises,
currency) denominated debt
— as opposed
is
that contracting "dollar" (foreign
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. 1 Yet there has been
into
why companies choose
little
Companies
to take on this type of debt.
systematic inquiry
certainly recognize
that contracting dollar debt brings with
it
the cost of a balance sheet mismatch.
other hand, the attraction to dollar debt
is
that a
nominally - at lower interest rates.
risk for a
company
in
Is
company
much
take on too
2
world.
-
at least
an emerging market?
Do
prices allocate the risk efficiently?
risk of dollar
Should a
debt and therefore
of it?
At an abstract
denominated debt
able to fund itself
the
the low price of foreign debt worth the balance sheet
maker be concerned that companies underprice the
policy
is
On
level,
is
the decision to take on dollar debt as opposed to domestically
a decision to opt out of insurance against bad aggregate states of the
Imagine a Thai company that faces a currency denomination choice
in taking
on
one period debt. Suppose that next period there are two (aggregate) states of the world: in
the good state the baht/dollar exchange rate
purchase a dollar and the exchange rate
will
have assets that are worth
of debt,
its
value next period
A
is,
Good
While
if
the
company took on
Normalizing by setting D^,
cases
is
in the
=
that in the former the
one, in the
bad
it
takes
more baht
two. In either state of the world, the
baht. Then,
if
the company chooses to take on
A - Dd
D
b
:
or
baht debt,
A - Db
its
Bad
A - 2D d
:
value
to
company
D d dollars
or
Bad
.
is,
:
A - Db
.
Db, we can see that the only difference between these two
company
is
required to
make an
additional
payment of Dd
bad state of the world. Thus, one can see the benefit due to issuing baht debt as
that of purchasing insurance against the bad aggregate state.
1
state
3
:
Good
is
is
For models of the balance sheet channel in emerging markets, see
The
e.g.,
firm buys a put option
Caballero and Krishnamurthy
Krugman (1999), Aghion, Bacchetta and Banerjee (1999), Chang and Velasco (1999).
From general equilibrium asset pricing results, it may seem odd that we refer to insuring against
(1999),
2
gate shocks.
3
We
With heterogeneity such insurance
have assumed there
is
no bankrupty
is
desirable, will be traded,
here, or that
A>
2Dd-
and can
affect real
aggre-
outcomes.
paying
which
Da
is
in the
bad state of the world. The cost of
this strategy
the option-premium,
is
reflected in a higher ex-ante interest rate vis-a-vis the dollar-interest rate.
model
In our
agents are risk neutral but domestics value and
all
4
demand insurance
because they face a risk of liquidation (or production interruptions) in bad states of the
a result of the
binding for the country.5
may become
world as international financial constraints
If,
as
agents expect the exchange rate to depreciate sharply during bad
latter,
aggregate states of the world, they will provision international liquidity for these states -
meaning they
will
"purchase" insurance that pays them dollars in the bad states of the
world.
The question we ask
Domestics
surance.
view only
if
whether domestics purchase a
demand
—
mestic firm can pledge
exchange rate indeed
its
financial
an extra unit of international liquidity
markets are well developed,
of in-
in
(assets).
the sense that a do-
from investment to domestic lenders, the
entire marginal product
reflects this
amount
—in our model, the relative price of foreign to
reflects the social value of
show that when domestic
socially efficient
the right amount of insurance from the social point of
the equilibrium exchange rate
domestic assets
We
will
is
marginal product and microeconomic insurance decisions
support the second best. But when domestic financial markets are underdeveloped, domes-
demand
tic
for international liquidity
is
determined by the limited availability
is
by marginal product. The empirical counterpart of
of domestic collateral rather than
scenario
during crises
this
a wedge between the internal return on investment for a domestic firm and the
external return that
is
promised to lenders. As a
result, international liquidity is underval-
ued, and insurance to guard against a lack of international liquidity
is
eschewed by domestic
firms.
While also driven by an insurance mispricing mechanism, our explanation
dollarization
is
quite distinct from ones that point out that fixed exchange rates offer free
insurance and creates moral hazard that distorts investment choices (see
and Burnside, Rebelo and Eichenbaum (1999)). In these models,
offers free insurance to firms that
borrow
rowing. In our model, on the other hand,
in dollars
it is
e.g.,
fixing the
Equivalently, the benefit due to issuing dollar debt
paying
Da
option
premium
it
if
the bad state of the world arises.
in
is
Dooley (1997),
exchange rate
and therefore encourages
dollar bor-
not government misbehavior but financial
underdevelopment that creates the private underinsurance problem. This
4
for liability
the
A company
premium on
may
explain
why
selling a foreign currency option
that chooses to issue dollar debt receives this
terms of a lower nominal interest cost, but faces the
risk that in
bad states of the world
must make a higher payment.
5
The hedging motive,
as in Froot, Scharfstein
constraints create hedging
demand
in a
dynamic
and Stein (1993), stems from the observation that
setting.
However,
in
our case, the hedging
from from an equilibrium-aggregate rather than a microeconomic constraint. The distinction
since
we address
a set of macroeconomic issues surrounding hedging.
financial
demand stems
is
important,
the dollarization of
liabilities
change rate systems.
problem extends across emerging markets, regardless of ex-
6
In addition to domestic
demand problems, under-insurance may be
driven by external
supply problems. This has been emphasized in the policy literature. For example, Haus-
mann,
from foreign investors
and Guidotti (1990)
is
emerging markets as the inability to borrow
et al (1999) refer to the "original sin" of
in
A
domestic currency.
in the context of public
formalization of a supply effect
is
in
Calvo
debt (see also Calvo (1996)). The argument
based on time-inconsistency of the government: ex-post governments will always devalue
denominated debt. Seeing
to reduce the value of local currency
from domestic currency debt. 7
lems.
We
'
8
Our framework adds
this, foreigners
naturally to the
list
shy away
of supply prob-
extend our model and show that domestic financial underdevelopment can affect
foreign lending supply
and insurance
foreign lenders find that
it is
in
two ways.
less profitable to
their entry into domestic financial
markets
is
development
First, as financial
falls,
lend to firms with poor collateral, and hence
cut back.
Second,
when
interacted with a
thin-market supply externality, we show that this withdrawal raises the risks that the fewer
suppliers are exposed to
The next
and hence can feedback
into higher lending
and insurance premia.
section of this paper lays out the model, while section 3 describes the un-
derinsurance problem. Section 4 explores in depth the connection between underinsurance
and domestic
5,
financial underdevelopment. This section also serves as a transition to section
where we discuss external supply problems that
contains final remarks.
An appendix
may
follows.
See, e.g., the evidence of dollarization of liabilities in fixed as well as flexible
Hausmann
7
Section 6
arise in this context.
exchange rate systems
in
et al. (1999).
See also Allen and Gale (2000) for a similar argument. In their model, banks optimally invest in foreign
bonds and issue domestic bonds. They argue that the
risk of inflation
may
dissuade foreigners to purchase
the domestic bonds. These explanations seem most compelling for high inflation countries (Latin America),
rather than, for example, the Asian countries where chronic inflation
Calvo (2000) points out,
connection between
Moreover, as
hard to extend this argument to private sector debt
if
one
The problem
is
that the private sector
liability dollarization
has incentives to choose
indeed costly.
it is
was not a problem.
its liabilities to
Our explanation accounts
and
financial difficulties.
hedge
its
assets
for private sector
is
interested in the
and avoid balance sheet mismatches,
debt choices, and
is
if
they are
designed to address precisely
this difficulty.
Constraints on domestic currency external borrowing
may have
a domestic policy origin as well. Until
recently in Chile, for example, external borrowing in domestic currency
borrowing.
was taxed more heavily than dollar
The Model
2
we
In this section
present the core model.
has three basic ingredients,
It
necessary to address the issues highlighted in the introduction: First,
international insurance
shocks. Second,
third,
it
on the presence of external
them
roots the need for
financial constraints
and country-wide
denomination of external debt to the insurance problem.
links the
it
it
of
all
And
on exchange rate
highlights the role of imperfections in domestic financial markets
determination and insurance demand.
Preferences and Technology
2.1
Consider a three period world indexed by
=
t
entrepreneurs/firms and foreign investors.
Assume
that there
is
0, 1, 2.
There are two
sets of agents:
domestic
and competitive.
All agents are risk neutral
a unit measure of each type of agent. Domestics borrow from foreign
and
investors, contract debt repayments,
invest in production at date
Then
0.
at date
1,
there are idiosyncratic and an aggregate shock that determine the injection of funds required
to continue production.
The aggregate shock only
takes on two values:
we
between the high (aggregate) state and the low state depending on the
debts are fully repaid and
2,
Production.
All production requires imported or dollar goods
or baht goods.
At date
a firm borrows
c(k)
The
function c(k)
solution.
Once
fc
<
created, the capital
is
"baht" -
b
it
date
1
2, if all
production
We
things go well, capital generates
may be
in order to generate
an interior
generates local currency revenue, and
value as collateral will vary with the exchange rate.
At date
this for
at a cost of c(k). Thus,
assumed to be convex and increasing
is
and produces domestic
from a foreigner, exchanges
6o dollars
imported raw materials and creates capital of
size of the shock.
agents consume.
Finally at date
all
shall distinguish
Rk
formalize this below
its
9
units of baht goods. However, at
interrupted by an idiosyncratic liquidity shock, and the firm
is
required to import an additional one unit of foreign goods per unit of capital in order to
realize
output of
Rk
on the capital that
of
its
is
baht. If a firm chooses not to, then
capital units, then date 2 output for this firm
this firm
9
is
tor<R = r + A
entirely real,
is
<
1
is,
must import 0k units of goods to compensate
the aggregate state
Our model
falls
+ 0Rk,
We assume that when the aggregate state is good,
When
output
not saved. Thus, suppose that a firm chooses to save a fraction
(l-0)rk
and
its
no firm
for the shock.
is
affected
by a
liquidity shock.
bad, on the other hand, half of the firms need to reinvest.
hence any allusion to the exchange rate refers to the
real
exchange
The
rate.
shock
bad
is
country- wide in the sense that a positive measure of firms are affected by
state, while
affected
by
good state
is 1
At date
date
it is
in the
it
2,
bad
state.
10
The
probability of the bad state
is
n, while that of the
— 7r. n
the domestic entrepreneurs/firms pay off
Ud =
where c B
is
c
B + cD
c
consumption of baht goods, and c D
may be
Foreigners
in the
idiosyncratic in that an individual firm has a probability of I2 of being
all
debts incurred at date
from production proceeds and consume the excess. Their preferences
1
it
•l
called
B ,c D
are,
>0
consumption of dollar goods.
is
and date
on at date
and
1
to supply dollars to domestics to
finance production. Their preferences are over consumption of dollars (foreign goods) at
all
three dates,
These preferences pin down the dollar
risk free interest rate at one.
International and Domestic Financial Markets
2.2
Foreigners do not consume any of the output from domestic capital.
This
is
the sense in
which capital generates only local currency revenues. Goods produced using domestic capital are
non-traded, so that the value of capital
falls
as the exchange rate between these baht
goods and dollars depreciates. Note also that because of
in
baht goods.
We
shall
assume that domestics have an exogenously
of foreign currency revenues arriving at date 2 given
willing to accept baht
exchange
for
denoted as
e
this, foreigners
specified
endowment
by w. Thus, while foreigners may be
will
immediately swap these
in
The exchange
rate for this transaction
is
goods as repayment on debts, they
the foreign currency endowment.
cannot be repaid
(baht per dollar). However, for expositional purposes
it is
easier to proceed
by assuming that foreigner lend only against the foreign currency revenue stream of w, so
that any swapping of baht for dollars
10
The
fact that heterogeneity rises during
is
only in the background.
bad states
is
not important.
We
need heterogeneity
state for domestic financial markets to matter, but adding heterogeneity in the
in the
bad
good aggregate state would
not add any substantive insight and would complicate the expressions.
11
R
We
also
need to make an assumption that date
investment in capital
is
sufficiently profitable.
Thus,
and r are high enough that,
(1
where
w
is
the firm's date 2
endowment
- n)R +
k^y1
>c(w),
of foreign currency (see below).
This expression just says that despite the possibility of the production shock at date
profitable. Finally to guarantee
an interior solution
(1
- n)R +
(i.e.
fc
<
l
c~ (w)) we assume that,
n^^- <(R~ r)c'(w).
1,
investment
is
Assumption
1 (Foreign Lending)
All foreign lending takes the
form of debt contracts
currency collateral of w. Lending
is
is
that are fully secured by the foreign
default free, so that the
maximum repayment on
debt
w.
By
debt we
mean
contracts that are not contingent on purely idiosyncratic performance.
As one might imagine,
flexibility in specifying
Of
firm could provide greater insurance.
debt repayments contingent on the type of
course, in practice, these shocks are idiosyncratic
and may be hard to observe so that contingent contracts are not enforceable.
Assumption
the date
1
2 (Non-observability of Production Shock) The identity of firms receiving
production shock in the low state
is
and
private information of the firm,
is
not
observable by any lender.
Debt repayments
aggregate state,
are,
however, assumed to be
To be more
to.
u £
Definition 1 Let
made
contingent on the (observable)
precise:
{l,h} be the state of the world at date
A
1.
date
dollar debt
contract between a domestic firm and a foreign investor will specify date 2 repayments, f",
and date
funding of
bo dollars.
Since foreign investors are risk neutral, competitive, and
the dollar interest rate is one,
b
=
l
7Tf
+
(1
- n)f h
Additionally, since all debt is fully secured,
f
As we argued
is
equilibrium, e
liabilities is
making
<w
in the introduction, the question of dollar liabilities vis-a-vis baht liabilities
simply a question of
l
w
>
e
h
.
how high /
is
relative to
f
h
.
We
shall shortly prove that, in
Since the effective baht repayment for the firm contracting dollar
e^/", equal dollar repayments in high and low states would have the firm
larger baht
denominated, then
repayments
/'
in the
would be lower
low state.
for
On
the same f
the other hand,
if liabilities
were baht
h
.
Unlike foreigners, domestics do value baht revenues, so they are willing to lend to each
other against domestic capital. However, the domestic financial market
so that not
all
of the output from capital
is
is
(l—9)rk+9Rk would be domestic
clearly larger. In section 4,
we
shall
underdeveloped,
pledgeable to a domestic lender. Only rk of
the date 2 goods serves as domestic collateral.
developed, then
is
Instead,
if
collateral.
work through
the financial market was fully
For 6
>
0,
the latter expression
this case to clarify the model.
Assumption 3 (Domestic
Domestic firms may lend
is fully
Lending)
each other at either date
to
secured by baht revenues.
or date
However, the domestic
credit
1.
All domestic lending
market
is
underdeveloped,
so that only rk of the date 2 baht revenues can be used to secure financing
from another
domestic.
The
limited domestic lending part of this assumption
underinsurance
result, for
it is
is
the central ingredient for our
responsible for the emergence of a gap between social and
private valuation of external insurance.
This
be clear after we describe
will
determining the equilibrium exchange rate during external
its
role in
crises.
Decisions and Equilibrium
2.3
Let us suppose that a firm borrows &o funds at date
and creates capital of
0,
k.
At date
there are two possible states of the world. In the high state, there are no shocks, and
firms continue to produce Rk. Net of the repayment of f
in the
h
,
1,
all
this implies that entrepreneurs
high state consume,
V h = Rk + w -
h
f
.
In the low state, firms are divided into two groups: those that receive the shock are
distressed, while those that
do not are
intact. Consider the
raising funds to alleviate its production shock.
2 of (1
— 6)rk + 9Rk
raise finance
and
A
problem
for a distressed firm in
choice of 9k will result in output at date
goods. In order to save a fraction 6 of distressed capital, the firm must
reinvest 6k imported goods. It can do this in
can go to foreigners to raise additional funds. That
is
two ways.
First, the firm
the firm can always raise directly,
h < w - f.
The
latter quantity will
firms,
date
A
which
also
1 is also
w—
always be positive in equilibrium. 12 The rest must come from intact
have access to foreign investors since their capacity to borrow abroad at
l
f
.
distressed firm can use its baht collateral of rk to
Since the exchange rate
from intact
firms.
is
e
Through
markets in our framework
economy and pledge
l
,
the firm can borrow a
this "credit chain"
— the distressed
firm
borrow dollars from intact
maximum amount
of
6f <
firms.
^r dollars
— which represents the domestic financial
is
able to aggregate the resources of the
this to foreigners to raise funds for date 1 reinvestment.
We
can then
write the problem of a distressed firm as,
Since firms are ex-ante homogeneous
w>
/',
otherwise there would be no international liquidity
the aggregate in the low state. But since reinvestment must be sufficiently profitable for external
be interesting, we rule out such corner.
left in
crisis
to
f
V
(PI)
l
s
s.t.
=ma,x gbib r>
w + (l-6)rk + 6Rk-
(t)
h
(n)
£ + h<w-f + $
(Hi)
Ok
than
and
l
= h +^
< < 1.
(iv)
(i)
(9
are balance sheet constraints (net marketable assets greater
(ii)
the resources received by the firm at date
(iv) is
An
new investment must be
while constraint (Hi) reflects that
liabilities),
intaking on debts of
1
b\
fully paid
and bf
with
Constraint
.
purely technological.
intact firm at date
has only one decision:
1
how much
finance will
distressed firm. Suppose that the firm accepts claims at date
baht) in return for making a date
1
it
extend to the
of x\ (face value of date 2
l
1
V}
(P2)
contribution of x\^/e dollars, then,
w + Rk +
= max Xl
x1
-
^
f<w-f
s-t.
The
-h-bf
<w- f
b
Constraints
l
constraint reflects the fact that an intact firm can, at
maximum,
lend
w—f
l
dollars to
the distressed firm.
Date
At date
problem.
0,
a firm looking forward to date
and
either distressed or intact,
1
can expect to find
itself
as
low or the high state. Thus the decision at date
in either the
is,
maxMoJ .
(F3)
- *)V h + tt(FJ + ^)/2
(1
s.t.
f
b
h
J <w
l
=
c(k)
An
Equilibrium.
(fc,6o,/^)
and
(9,
equilibrium of this
6f ,&f,
xf ),
=
economy
respectively,
problems (PI), (P2), and (P3) given
firms'
irf
+
(1
- n)f h
bo-
consists of date
and prices
prices.
e".
and date
1
decisions,
Decisions are solutions to the
At these
prices, the
exchange market
clears.
The only
equilibrium price
following
must hold
Lemma
1 Let c
in the domestic
•
If c
and
0,
the exchange rate. Given the preferences of domestics, the
true.
denote the equilibrium consumption of any intact entrepreneur
c
economy
B ,c D >
is
at date 2.
thene
=
1.
Then,
•
Ifc
The
B >
0, but c
case of c
B
D =
=
then e
0,
and
c
D >
>
0,
1.
can never occur in our model since production always
generates at least some baht, and the domestics must consume this baht.
The exchange
rate
is
as long as the solution
1
both baht as well as dollar goods. However,
exchange rate
we
shall
the economy runs out of dollar goods, the
will depreciate further to reflect this scarcity. Since this
be interested
the low state.
if
with domestics consuming
interior,
is
13
in,
we
shall construct
The equilibrium exchange
an equilibrium where
rate, e
l
is
this
precisely the case
is
happens at date
in
1
determined in the domestic financial
market, where intact firms lend dollars to distressed firms against baht: 14
It? = 1*?
Let us
now study
equilibrium in
faces the choice of restructuring
more
in
I- state
(i)
Consider a distressed firm that
detail.
an additional unit of capital at date
1.
Let,
A = R-r
be the baht return to saving one unit of
baht and one dollar equally
A>
1
,
for
capital.
remember that a firm values one
D + c B ). As a result, if
(i.e. U = c
First,
consumption at date
2
then the distressed firm would choose to borrow as much as
it
can against
its
foreign
A
currency revenues at the dollar interest rate of one, and reinvest these funds to return
baht goods at date
1.
h=w-f.
If
the amount raised from international investors,
the shortfall.
e
It will
.
It
can
sell
up to rk date
choose to do this as long as
the exchange rate.
w—
/', is less
than the funds needed
have to access the foreign exchange market to make up
for restructuring, k, the firm will
l
(2)
2 baht to another domestic at the exchange rate of
A>
e
The maximum amount
,
or the baht return
of funds raised
on restructuring exceeds
is,
r
b?
As long
k,
as the
the firm
13
is
sum
of ^y and the right
unconstrained in
1
but not at date 2 (liquidity
the qualitative aspects of the issues
The
(3)
side of (2)
is
reinvestment at date
1
more than the borrowing need
and
all
of
production units will be
See Caballero and Krishnamurthy (1999) for a variant of this model where the shortage of dollars occurs
at date
14
its
hand
< 4-
More
precisely,
what we
we
"fire sale"
dimension of the problem
the exchange rate at date
is
1,
one and interest parity must hold.
is
The model has
domestic interest rate. Choosing
This
i\
=
not important for
is
are addressing in this paper.
refer to as
international interest rate
the domestic interest rate.
crisis).
0,
a free parameter in that
a date 2 forward exchange rate.
Thus, ei(l
we do
allows us to call this the date
1
+
=
ii)
e2,
where
not, nor need to, pin
exchange rate as
well.
i\
down
is
the
saved. In this case, the firm will borrow less than ^f (and perhaps less than the international
debt capacity).
most
Intact firms can tender at
their excess international debt capacity of
They
return for purchasing domestic debt.
> 1.
moment that A >
rate exceeds one, or e
Assume
for
a
will
w—
all
f goods, which
choose to do this as long as the exchange
e
>
l
is
borrow as much as
so that distressed firms
1
Then,
directed to the distressed firms.
is
production units to be saved
the economy can
in total
A
necessary condition for
that,
<*»-"?;
(4)
f
If this
constraint
is
violated, then
some
9- =
2
capital units are not restructured at date
w-f
shall refer to this constraint as the international liquidity constraint.
nor
(4) binds, all
production units are saved. Since in equilibrium
is
1,
0<1.
l
J
We
the exchange rate
in
f
l
they can, and intact firms lend as much as they can.
import
w—
c
>
When
0, it
neither (3)
must be that
one.
The other extreme
case
when both
is
(3)
and
Equilibrium in the exchange
(4) bind.
market requires that,
rk
-r
el
Since (3) binds, distressed firms
sell all
A
= W-f.
of their baht revenues to intact firms.
many
intact firms purchase this by borrowing as
distressed firms. Solving for e
l
,
(4) binds,
and paying
this to
yields
'-^ho
In this case, the exchange rate
dollars as they can
As
is
1
-
depreciated since there
<
is
5»
a scarcity of dollar assets relative
to baht assets.
Now, depending on parameters, there are
I
four regions that
may
occur at date
- distinguished by the four combinations of binding constraints, (4) and
(3).
in state
1
We
focus on
the cases where the international financial constraint (4) binds, and study cases in which
the domestic constraint (3)
state
is
or
may
not bind.
If (4) binds,
the exchange rate in the
/
depreciated.
Lemma
Lemma
may
2 (Exchange Rates) If (4) binds, then c D of an intact firm at date 2
1,
we can conclude
than zero, and e
=
1.
that e
l
In the high
>
1.
If (4) does not bind,
state, since there are
10
no
D
c
is zero.
of an intact firm
liquidity shocks, e
—
is
1.
From
greater
With
on
just this constraint, firms will anticipate that taking
baht payments in the
I
in this state.
We
will
where they
state. Since this is precisely the state
to finance the production shock, they will shy
show that
away from contracting
will
need resources
make high payments
to
in this case, firms appropriately value the insurance offered
by contracting domestic currency debt. This changes when
are credit constrained.
dollar debt implies higher
We shall
show
(3) binds,
in this case that there is
and domestic firms
an externality whereby firms
undervalue insurance against the low state.
Currency Denomination
2.4
as
an Aggregate Contingency
Let us pause at this juncture and contrast dollar debt and baht debt within our framework.
An uncontingent
repayments of f h
dollar debt contract will specify
since the dollar interest
=
f
l
=
fdollar- Therefore
one,
is
= ^ fdollar +
bo,dollar
(1
~ ^)fdollar = fdollar-
Next consider an uncontingent baht debt contract with repayments given as f h
The
fbaht-
state,
where
at date
repayments are
dollar equivalent
e
l
>
1.
the high state, and
fbaht in
Thus, the amount of dollar equivalent that the firm
^f^
is
=
in the
f
l
=
low
able to borrow
is,
J baht
j-
+
,
i ,
(1
-
s
~ ^(e -
TT) fbaht
=
Jbaht
=
=
f Then
\
c
t
I
i\
1)
J
baht
e'
Let us normalize by choosing, fdollar
fbaht
—
it is
r-
&
easy to see that,
bo dollar
^v.aoaar
-
n{e
" v>-
or that, for a fixed face value of debt, the firm
is
able to borrow less dollars by issuing baht
JQ.baht
—
t
l)-r,
*j
el
i
debt than dollar debt.
The reason behind
vis
this
is
that the firm takes exchange rate risk in
baht debt, when the firm borrows in dollars
one on / baht. Equivalently the firm
it
is
it
simultaneously
sells
its
debt
issue. Vis-a-
a put option struck at
able to obtain a lower interest rate on
its
debt when
takes on dollar debt than baht debt, but in return takes on the risk that the exchange
rate
may
depreciate at date
With these
3
3.1
1.
preliminaries behind,
we can turn
to our
main substantive
results.
Underinsurance: Excessive dollar Liabilities
Competitive Equilibrium versus Planner's Choice
Definition 2
// f
h
and f are debt repayment choices
decentralized equilibrium,
and
F
h
and
F
l
(in units of dollars) in a competitive
are debt repayment choices of a central planner,
11
then
we
shall say that the
The
economy has excessive dollar
fh
Fh
fi
Fi
liabilities
if,
behind this definition stems from the previous section.
logic
When
normalized
and baht
so that all repayments are in dollar terms, the only difference between dollar
contracted debt repayment
in the size of the
is
repayment
in the
I
Taking on dollar debt means, per unit of debt, higher repayments
now
Let us
(3)
and
write
(4) bind.
A
and (P2).
down the date
I
state.
state.
15
decentralized problem in an environment where both
h
choice of (k,f ,f
debt) in the high state
l
result in date 2 resources (net of
)
from (PI)
any contracted
of,
w- f h
Rk +
On
in the
First, let us rewrite (P3), substituting in the value function
date
h
state versus the
the other hand in the low state,
if
(
the firm
.
distressed,
is
it
has date 2 resources
of,
w -f)A + ^-A
e'
This
is
because (w
—
project return of A.
/') is directly
The rk
the proceeds invested at A.
pledged to foreigners, and the proceeds invested at the
of domestic collateral
If
the firm
is
[w
Thus the date
(PA)
program
maxkif K if
l
l
)e
sold at the exchange rate of
+
w-f h
(l~n)(Rk +
i
f
h
Rk.
+ nl{(R + r^)k + (A +
)
=
l
irf
+
who maximizes an
Suppose the central planner makes a date
up with resources
V h = RK +
We allow firms
(/ >/
)-
To map
1
))
choice of
(K,Bo,F ,F
Then, at date
),
where
1,
in
l
W - Fh
and have them choose the pattern of payments
language of uncontingent baht and dollar debt contracts, note that
spanning results apply. The pattern of repayments of (f
We
the
.
there are two states of the world and that these two (uncontingent) liabilities are linearly independent.
debt and some dollar debt.
sum
of,
to take on contingent dollar debt contracts
this directly into the
equally weighted
and international borrowing
capital letters denote the central planner's aggregate quantities.
15
)(w-f
(l-ir)f h
of the utilities of the domestic agents, subject to the domestic
firms will end
l
l
Consider next the choices of a central planner
all
e
J <w
c(k)
high state,
and
is,
s.t.
constraints.
e',
date 2 resources are,
intact,
-f
is
say there
is
h
,
/')
can be implemented by taking on some baht
excessive dollar debt
lower fraction of dollar debt than private agents.
12
Thus
when
a central planner would choose a
In the
I
state,
a distressed firm receives,
(W - F )A +
l
But
we
since
^A.
are interested in an expression that
is
free of prices,
simply substitute the
market clearing condition,
,
tK
-
e
W -F
Then,
into the above.
VB = 2{W - F
l
Similarly,
l
)A
l
an intact firm receives,
[W—F )e + RK.
l
l
And
substituting in the market clearing condition,
=
Vl
Therefore the constrained
max KFhF
(P5)
debt choices in this economy
efficient
F h ,F
s.t.
h
are,
16
)+n\({R + r)K + 2A{W - F
l
<W
l
=
c(K)
The
W-F
{l-Tv){RK +
i
+ R)K
(r
ttF
1
+
- w)F h
(1
objective in (P5) represents the constrained efficient solution as opposed to the
best solution.
Our
central planner
the economy raises ivF
Lemma
+
1
—
(1
is still
ir)F
h
subject to the international debt constraint -
which
Fh =
3 In both (P4) and (P5),
first
f
is
h
limited by
i.e.
W.
= W.
Proof: see appendix.
The
there
is
fairly obvious. In
the h state, since there
no reason to leave an slack
is
borrow
date
result
as
much
in
W
as possible against
is
the debt repayment.
in this state
no chance of a liquidity shock,
Optimality requires firms to
and use the proceeds to increase
K
at
0.
Lemma
4
If
A >
e
l
,
then
F <
l
l
f
,
or debt repayments are set too high in the
I
state in
1
dollars of
the decentralized equilibrium.
16
This expression can be arrived at directly by noting that
if (4)
the economy must go toward saving capital units. Since there are
aggregate, and each generates a return of A,
reduces output to
rK
for one-half the firms,
we have the
l
all
the date
dollars that the
latter half of this expression.
we have the former part
13
binds, then
W—F
of the expression.
economy has
in
Given a shock that
Proof: see appendix.
The
way
easiest
corresponding to the
to understand this result
I
to contrast the terms in the objectives
is
and (P5). Suppose that / and
state in both (P4)
Now, imagine an experiment of increasing f and F by $1. In both cases
for more borrowing at date 0, and will raise an additional tx dollars. This
l
used to increase capital investment by pr^y
investing
Now
cases.
In both cases, there
consider the cost.
distressed capital units in the
I
were equal.
this will allow
in
turn can be
Therefore the benefit to borrowing a dollar and
.
same amount
to increase capital by the
it is
F
l
state at date
1
-
in
is
(w
i.e.
both centralized and decentralized
one dollar
—f
l
)
falls
funds for saving
less of
by one
The
dollar.
firms
in (P4) take this cost to be,
while the central planner recognizes that this cost truly
-2A =
is,
A.
2
The
central planner's cost of taking on the extra dollar of debt exceeds the firm's perceived
cost by,
As long
as
A>
e' it
must be that firms
set /'
> F
l
.
Definition 3 Define the index of domestic underdevelopment as the difference
be-
tween the marginal profit of saving a distressed production unit and the exchange rate of
e
l
.
Sd
Then note the
Lemma
e
h
=
then
1.
it
l
,
following:
// (3) also binds, then
must
be that Sd
greater than zero
environment
=
e
5 (Domestic Underdevelopment) Suppose that (4) binds in the
The reason we
sd
=A-
in
=
it
must
>
0.
l
>
Alternatively, if (3) does not bind,
0.
refer to Sd as the
when
be that Sd
state so that e
I
index of domestic underdevelopment
is
that
the credit constraint between domestic firms binds
which there are no domestic credit constraint
is
it is
only
(i.e (3)).
An
analogous to one in which
0-
Proof: Consider the
the firm finds
it
FOC
profitable to
for the
borrow
Assuming maximum borrowing,
e
l
=
exchange transaction by a distressed
as
much
rk
.
fl
A>
e
l
,
as possible against its baht revenues of rk.
Now
14
firm. If
there are two cases. If
A>
_f
t
,
this
is
an equilibrium and both
case
maximum
when, at
is
to borrow as
capital
is less
much
and
(3)
borrowing,
A
<
>
l
that s d
we have
>
0.
Here, a firm will not find
.
_J^ fl
than or equal to the exchange
A—
e
=
l
0,
rate.
we have that
As a
s
d
Firms
(Excessive dollar liabilities.)
1
e
The
other
profitable
it
as possible against rk since the return from saving a distressed unit of
bind. Additionally, since
Proposition
A—
binds and since
(3)
=
result,
<
6f
and
^V,
(3)
does not
0.
economy
in an
in which Sd
>
0,
hence
(4) are binding, contract excessive dollar liabilities.
3.2
The Externality
When
a domestic firm makes
its
financing and production choices,
it
looks not only at the
revenue generated by capital investment but also at the liquidity services that this capital
provides at date
That
1.
investment decisions
completed.
the creation of a liquid asset
is,
when a sudden need
From the aggregate
liquid assets
is
for fresh resources
an important aspect of real
may
arise before projects are
point of view of the central planner, only internationally
have such value, since date
1
may be
production needs
satisfied only
with
dollars.
Comparing (P4) and (P5)
at /'
= F
l
reveals that, relative to the central planner,
individual agents add a term to their objective function which
microeconomic liquidity service of domestic and international
4((A-e<)^-(A- e
When the economy
in the
the margin
If distressed, at
its
is
state, a firm
I
it
uses
its
may be
coincide with that of the central planner, there
s
d
>
full
directly related to the
assets:
(u,-/<)).
(6)
distressed or intact with equal probability.
domestic asset
international liquidity to distressed firms.
the latter must yield the
<)
is
(i.e.
rk) as collateral.
In order for the microeconomic problem to
must be no rent
in the
marginal product of reinvestment.
former activity, while
It is
apparent that when
neither condition holds; the collateral value of domestic assets
the return on supplying valuable international liquidity
Both problems have the same
root.
If not, it sells
When
is
is
overvalued while
depressed.
domestic financial markets are underde-
veloped, distressed firms can only pledge a fraction of their marginal product of date
investment of A.
news
for
assets,
The
constrained nature of their
demand
for international liquidity
is
1
good
a distressed firm in need for such liquidity and in possession of pledgeable domestic
because
it
faces less competition for international liquidity,
retain a fraction of the surplus from fresh investment.
attempting to profit from
its
It is
and
bad news
is
for
thereby able to
an intact firm
international liquidity, because this firm receives less than the
15
social surplus
spread of
A
4
Sd-
due to investment. Both margins are distorted exactly by the domestic credit
U
Closer Look at the Connection between Financial Un-
derdevelopment and Underinsurance
We
have argued that excessive dollarization of
market underdevelopment.
When
between domestic agents, agents
on domestic currency
steps. First,
we
liabilities
stems from domestic financial
there are credit constraints affecting borrowing/lending
will systematically
liabilities affords.
undervalue the insurance that taking
This section develops this argument further
from the direct
effect of credit constraints
Second, we show that when domestic financial constraints vanish
is
two
relax the credit constraints of a few domestic agents in order to separate the
effect of distorted asset prices
best
in
for all
We
conclude that
it is
choices.
domestics the second
attained, despite the fact that the aggregate shocks have a real
on the economy.
on agents'
and negative
effect
domestic financial constraints, rather than negative
shocks, which are behind our underinsurance results.
Constrained and Unconstrained Firms
4.1
Suppose that a fraction A of the domestic firms face no domestic credit constraints. Thus,
for these firms the
date
debt constraint
1
6f <
For 6
>
0, it is
is,
c-yy
(
7)
clear that,
(l-0)r + 6R,
k>
1
rk
—
or that these firms are less credit constrained than those of (3).
Lemma
17
6 (7)
will
never bind for unconstrained firms.
For the distortion in the relative valuation of the liquidity service of both assets to
case that r
>
0.
Otherwise, the
gives liquidity service,
and
all
initial capital
On
the other hand, the case where r
=
is
is
done via changes
constraint arising from the limited pledgeability of date
friction
would
no consequence as there
date
1
is
1
and domestic
16
if
r
=
we
Thus,
usually think that capital
but there
is
a domestic financial
any down payment available at date
liquidity at date
no action by a domestic that would
and therefore be altered by the distortion.
in financing decisions.
reinvestment, there would be no externality.
affect the leverage coefficient of
distort the relative valuations of international
must be the
not a sufficient condition for the externality to
non-generic in the sense that
investment creates a liquid asset as a byproduct. Nevertheless,
While such a
it
investment in k does not yield any domestic collateral that
liquidity provision can only be
to be precise, the presence of domestic financial constraints
arise.
arise,
affect the
1,
this distortion
amount
1,
and
would have
of domestic liquidity at
,
Proof:
Suppose that these firms chose to save 9 units of capital by issuing debt that
Then the maximum amount
garners 6k dollars.
of dollars they can raise
el
is,
el
Since,
R=r+
we can conclude
A>A>e
l
that,
(l-ey + oR
k>
6k.
el
Thus given any
6 these firms will always be able to obtain funds required to restructure
all
of their capital units.
program
Next consider the date
Rk + w — f
.
In the
I
state, if the firm
V\
while
if
l
l
s
is
at the
intact
is
it
= Rk + (w-
Vh =
before in the h state,
receives,
l
l
)e
f
distressed,
V =rk + (A- e
This
As
for these firms.
because the firm
exchange rate of
is
e
l
- f)e = Rk l
A
and generating
,
all
l
e k
+
(w
- f)e
of its capital units
baht at date
2.
l
by borrowing k
dollars
Combining, yields the date
firm:
(l-n)(Rk +
max kJ kji
s-t.
f
h
w-f h
+ n({R-^)k +
)
e
l
(w-f
1
)^
J <w
c(k)
Lemma
(w
always able to save
program of an unconstrained
(P6)
+
)k
l
= nf +
l
(1
-
ir)f
h
7 Let / w represent optimal choices in (P6). Then, for
A>
e
l
>
r
^
f
l
/'
Proof: see appendix.
Thus unconstrained firms are more
The reason
for this is that,
willing to take
on
on the margin, firms that
costly are the ones that prefer to take
on baht debt.
dollar debt
find balance sheet
firms.
mismatches more
However, unconstrained firms are
precisely the ones that can afford balance sheet mismatches.
17
than constrained
As a
result,
they undervalue
the insurance aspect of baht debt even more strongly, as they
prices brought about
now
Let us
by the constrained nature of
when A =
look at the limit,
liquidity
still
face the distorted asset
demand. 18
'
19
so that no domestic firm
1,
is
(domestically)
credit constrained. In this case, domestic firms follow socially optimal debt choices.
Lemma
8
=
X
If
one? (4) binds, then e
1
Proof: Consider investment
diction that
A>
e
Then the
l
.
Now
save production units.
domestic firm
and save
all
is
demand
and
at date
<
1.
from
Lemma
we note
6
=
1).
firm.
Suppose
borrow as much as
in contrait
can and
that (7) can never bind, or that the
(4) binds,
J
implies that,
This violates market clearing. There
The
1.
Thus,
bf>w-f
18
=
never credit constrained. This implies that distressed firms will issue debt
Which
must be that
h
by a distressed
1
2
for 6
e
distressed firm will choose to
of their capital units (6
However, since
=A
l
A=
e
is
excess
l
.
demand
for dollars at
date
1.
As a
result
it
l
.
restriction that r
<
e' is fairly
weak
in the sense that
it is
sufficient
but not necessary, and there
is
a wide range of parameters for which the result holds.
19
When
there
is
heterogeneity
among
domestics, the fact that the unconstrained firms take on excessive
dollar liabilities can be partially solved via private contracts.
0:
pay unconstrained firms
in
Imagine the following insurance contract at date
constrained firms receive dollars from unconstrained firms in the
any
case).
0.
state,
and
in
return constrained firms
the h state and in baht (out of the rk of baht collateral, which was unmortgaged
This contract would be possible
observed at date
The value
in
I
if
the type of firm (constrained versus unconstrained)
This seems a reasonable assumption
of a dollar in the
I
(i.e.
state to a constrained firm
credit
worthy versus
less credit
worthy
is
firms).
is,
^>.
while the cost of mortgaging one unit of the baht collateral in the h state
is
only one. Thus, constrained firms
are willing to pay a high price for this insurance contract. Unconstrained firms find that reducing /' in order
to take the other side of the insurance contract costs only
A
of
jp
by
The
selling this insurance.
firms' valuation of dollars in the
/
I
state
while they stand to reap as high as a
premium
price implicit in the insurance contract increases the unconstrained
state to
constrained firms in line with each other.
value of dollars in the
e',
*e
from
e
.
However, since
and the private value of
dollars
dollarized.
18
This brings debt choices of unconstrained and
A>
e', it still
leaves
and the economy
room between the
is still left
social
excessively liability
Now
e
l
if e
l
=
A, then Sd
=
(1
s.t.
This program
is
f
h
-
+w-
ir)(Rk
f
h
+
)
ir
(^k + A(w - /'))
l
Hence,
if
A
=
the economy makes efficient
1,
its liabilities.
Discussion
4.2
The economy with A =
has aggregate shocks and exchange rate fluctuations, yet there
1
=
no underinsurance. The only difference between the case with A
>
in the
I
state
when A =
0.
It is
>
domestics undervalue insurance against the
specification of shocks
state,
and Sd
=
in the
/
Hence we have argued that
0.
state.
At an abstract
theoretically possible to construct a
it is
I
state. In this case
reality
I
it is
by high domestic spreads, and only
indirectly
The
general principle behind our result
is
for
that
model
in
in this case
with a
which s^
different-
>
in the
result that domestics
state of the world.
perfectly
To
is
that there
is
us, this
in
underinsurance
worth pointing out that underinsurance
directly
demand
1 is
- domestic spreads tend to be higher
periods - thus the natural prediction of the model
against these states. Nevertheless,
=
The model we have presented
aligns the incidence of a high domestic spread with the
seems the empirically plausible model of
level,
we would have the odd
don't sufficiently value insurance against the h state.
crisis
and A
important to recognize that the underinsurance result
only arises in states of the world where Sd
h
(P6) modified to let
is
J <w
identical to that of (P5).
choices in the denomination of
Sd
a firm at date
for
=A.
max kJh ji
is
The program
0.
is
caused
by bad shocks.
that credit constraints leads to constrained
funds - those in need of funds are not credible in transferring surplus created
by these funds to the providers of these funds. Suppliers of funds,
find that the business of lending to firms with
bad
collateral
is
why
dynamic context,
not a particularly profitable
business and transfer their resources elsewhere. In the next section,
also helps explains
in a
we argue
that this logic
the entry of "specialist" foreign lending into domestic markets
(i.e.
retarded. This also suggests a supply channel for
why
credit line facilities, foreign banks)
is
foreign lenders are reluctant to lend in domestic currency.
5
Limited Foreign Credit Lines: Further Costs of Domestic
Financial Underdevelopment
Foreigners, thus far, are passive lenders.
They make no
profits
and simply lend
at the
international interest rate of one. Needless to say, such characterization of foreigners (and
19
—
many domestic savers)
is
hardly
of financial underdevelopment
realistic.
This section extends the model to study the
effects
we introduce an
active
on foreign lending
decisions. For this,
margin whereby foreign lenders may pay a fixed cost and choose to specialize
the domestic market.
it
The
takes.
in lending to
We characterize both the quantity of foreign lending and the form that
quantity results stem directly from section
If
4.
domestic financial markets
are underdeveloped there will be limited entry of foreigners into the domestic market, as
lenders find that the business of lending to firms with poor collateral
one.
we show
Conditional on entry,
extend look very much
like
increase the interest rates
not a profitable
that the optimal contracts that these foreign lenders
contingent credit
we introduce complementarities
lines. Finally,
and demonstrate how
in foreign lending decisions
is
financial
underdevelopment may also
and insurance premia charged by foreign
lenders.
Foreign Specialists
5.1
Let us return to the model of section
4.1,
F
1.
endowment
measure of foreign lenders, each with a date
can choose to pay a fixed cost of
< A <
with
(dollars) at date
Suppose that there
in dollars of
w^
.
is
a unit
Each lender
domestic
in order to "specialize" in
lending. If they pay the fixed cost, they can value baht goods as do domestic agents:
U = cD + cB
while
if
they do not:
U = cD
.
Paying the fixed cost allows specialists to count the rk of baht output as collateral
any lending. With
this modification,
we capture the idea that
for
specializing in the domestic
market enables the investor to receive higher returns on lending to domestics.20
A
specialist has
w?
But he can improve
dollars that he will invest in loans backed
return (see below)
its
with foreign non-specialists.
international liquidity
date
vjf dollars into
when
—
7T
he
if
first
by domestic baht
enters into a contingent agreement
In particular, he will want to have the
it is
most valuable (the
dollars at date 1 in the
I
I
state).
state
He does
— and
by transacting with other foreign non-specialist lenders. That
a contingent claim that pays - dollars in the
I
collateral.
maximum
so
possible
by converting
dollars in the
his
h state
the specialist invests in
is,
state. Since foreign non-specialists are risk
neutral, they would willingly supply such a claim.
20
Concretely, one might imagine these baht goods are acceptable
after date 2,
in this
way
and the foreign
retrieve his
specialist
payment
if
there are
many more
periods
can reinvest these baht goods in production of the export sector and
payments over time. In
knowledge of business practices that enables
this case,
we should
this specialist to
20
interpret
remain
in the
F
as the cost of acquiring the
domestic market.
e
The
rate of e
—
l
dollars can then
>
be invested against baht collateral at date
1
at the exchange
earning the specialist,
1,
—
baht at date 2 in the
I
Thus entry
state.
gives expected utility of,
Ue = w f e l
F,
while non entry gives utility of
U ne = w f
Let us denote by
market.
The
< a<
1
.
the fraction of foreigners that choose to enter the domestic
determines that a
free entry constraint
w f(e - 1) =
l
Note that
Sd
if
is
be limited.
will
high, then e
This
is
l
—
1 will
be low
is
such that:
F.
given participation) and foreign entry
(for
the effect of financial development on specialist entry.
Before
characterizing the equilibrium with entry, let us define the lending contract.
Contingent Lending Contract
5.2
Definition 4
A
(Specialist
Lending Contract)
and a domestic firm
contract between a foreign specialist
payments from
specialist to
will specify, (d$, d§,d§),
as
domestic firm. The resource constraint for the lender will require
that,
+ (l-vr)4 + 7r4 = ^.
d°
That
is,
the expected present value of these
(8)
payments must equal w^
(recall that the specialist
has already signed a contingent contract with foreign non- specialist)
specify baht
repayments of(t
h
,t
l
)
from firm
n
4-h
t
if the
firm
is
h
firm
The
is
last
The contract
will also
to specialist lender, satisfying,
J < Rk
l
,t
unconstrained, and
t
if the
.
A <rk
l
constrained.
two constraints are simply that promised repayments of
collateralized. Since the specialist
can always earn
e
—
l
1
on his
(t
h
,t
l
)
must be
dollars, the contract
fully
must
satisfy,
(1
-
n)t
h
+
wb
l
=
l
e (d°s
21
+
(1
-
7r)dJ
+
tt<4)
(9)
Consider next the problem
a constrained firm. In addition to making a borrowing
for
decision from foreign non-specialists,
it
can also choose to borrow from foreign
(1
- n)(Rk + w +
specialists.
Thus,
(P7)
rnax fei/
fc
i/i)do id id ,
£
>tV
Tri ((i?
si-
f
t
h
h
+
i'
(r
-
- fh -
lemma
following
Lemma
h
)
+
+ (A +
i')f )fc
l
-
<
e')(u;
+
4 - /'))
rk
tt)*'
1
+ Tri' =
e'(d°
c(A:)=^/'-+(-l-7r)/
The
t
,f<w
,t
(1
-
d£
ft
+ (1 +4
tt)4
+
tt4)
characterizes the solution to this problem.
9 (Contingent Credit Lines) The optimal
specialist lending dollars at date
and
at date 1 in the
receive baht repayments in the h state,
have the
specialist lending contract will
I
In return, the specialist will
state.
and potentially some baht repayment
in the
This can be interpreted as a credit line from which the firm draws down d$ at date
d$ in the
I
I
state, a fee
We
and pays a
state,
oft
fee oft
h
in the high state,
and
if
state.
I
0,
drawn down
the line is
and
in the
1
.
relegate the proof of this
lemma
to the appendix, but the essence of
can be
it
immediately seen from the structure of the constrained firm's problem:
•
For the same reason that f h
=
w, the firm will choose to set dj
having excess dollars in the h state
•
>
Moreover, since production at date
0.
Firms don't value having any slack
in the
Borrowing against one unit of domestic
date
in the
of 4- However, waiting
I
till
is
is
h
1
a profitable enterprise, dj
state.
t
=
As a
is,
since
1 in
/
I
l
t
>
borrow
state generates dollars at
borrow against unit of domestic
the
0.
rk.
collateral in the
to
>
result they will fully
state of
—
.
t
collateral
In the objective function,
weighted by n, and hence we can conclude that the firm
any choice of
is
indifferent
on
0.
Equilibrium, Entry, and Financial Development
Let us turn next to equilibrium and ask
date
date
state generates dollars at date
the latter
5.3
That
not valued, the firm would prefer to have none.
against their domestic collateral of rk and set
•
0.
Likewise since dollars are valued in the low state to cope with the production shock,
dj
•
is
=
how many
0.
22
specialists enter the
domestic market at
At date
in the
1
I
of domestic collateral
market clearing has distressed constrained firms
state,
and distressed unconstrained firms
=
l
then
t
0,
l
otherwise
t
>
0.
In fact there are two cases.
l
are indifferent on the choice of
t
21
.
For simplicity,
dollars:
,
_
(1
-
dj
a
that
valid)
is
X)rk
w- f
1
Rk — t
aw^e <
.
—
l
t
— X)rk + XRk,
(1
=
l
t
(there
Since intact firms have w — f
l
is
a
+ d'$
+ XRk
+4
specialists choose to enter the market,
=a
a*
.
1
If,
rk
As we noted, firms
l
us take the case where
let
wide range of parameters where this assumption
Now suppose
= 0, we have,
selling
selling
then rewriting
(8)
with
.
TV
Substituting this into the above expression yields:
l
e
= ((l-X)r + XR)
-
w— V+a
All things being equal, e
l
is
decreasing in a. In fact,
k,
f
«
wf
J
7T
and d^
changes since these quantities are determined in equilibrium. However,
^<
that
the
in
/
22
0.
As more foreign
state rises
specialists choose to enter the market, the
worth noting
static
market has more unconstrained firms so that
1
and the return on lending
demand
l
easy to show
supply of dollars
in
>
for
That
0.
more developed, there
it is
as the domestic
is,
and hence
the entry decision.
The
more domestic
is
e
l
rises.
Figure
solid line represents
funds as a function of the exchange rate. The curve
for foreign specialist
demand
represents
that^-
is
dollars to these firms rises
below represents this as an equilibrium
the
it is
e
and hence the exchange rate appreciates.
The next comparative
collateral
change when
will also
an economy which
is
more
financial developed
(i.e.
A
is
d!
higher). Since
foreigners require that,
l
e
+
1
=
—
w
jr
J
21
The
logic
behind this constraint
the h state. At
of
aw'
"
maximum,
this
is (1
that firms always prefer to pay foreign specialists with collateral in
is
— X)rk + XRk.
The
that enter the domestic market.
The algebra
is
as follows. Differentiating
de
•"'-*$
*
/'+Q„.
Foreigners require a return of e on the aggregate dollars
constraint follows.
and rewriting,
l
9a
x
\{1-X)r + \R
Since,
#r
,
In-
,
fl-f
<
0,
we have
the sign.
23
in order to enter, in
is
exactly e
=
l
1
+
—
-±j
w
the region where
a <
a
1,
1.
f
a
Figure
Lemma
a
Entry by Foreign Specialists
<
1
and
l
t
=
specialist entry into the
0,
a
is
increasing in A. Financial develop-
domestic lending market.
Supply Multiplier and Financial Development
Let us pause for a
is
1:
10 In the region where a
ment increases foreign
5.4
such that the equilibrium exchange rate
is
moment and take
stock.
Our explanation
that domestic firms look at the interest rate charged
this to the interest rate
when borrowing
charged in dollars, fully recognize that there
they opt for dollar borrowing, and yet conclude that
the central planner does) in dollars.
The explanation
insurance against bad aggregate outcomes. But
another side of the story. Lenders
vis-a-vis lending in dollars,
the former option.
for excessive dollar liabilities
—
i.e.
it
it is
is
in baht,
compare
exchange rate
risk
preferable to borrow (more than
rests purely
on domestic demand
would appear that
mostly foreigners
in reality there
is
it is
for
also
— may evaluate lending in baht
and conclude that they require an extremely high premium
Below we show that
if
for
possible to connect such supply response to
the very same deficiencies that led to depressed demand.
Of course, one
to
what?
In our
tricky question that needs to be addressed
model with passive
eigners were risk neutral
fair prices.
is:
too high a premium relative
foreigners, this question could not
and competitive and provided insurance
be addressed. For-
elastically at actuarially
Introducing foreign specialist lenders gives a point of comparison whereby this
question can be addressed.
24
We
have already seen that foreign specialists provide an insurance role by entering
market and accepting baht
into the domestic
collateral against their loans.
Indeed, the
contingent credit lines that they extend are fashioned to provide insurance against the
state (especially
when
l
t
=
Limited insurance supply would
0).
mean
that foreign specialists
require too high a return on their provision of contingent credit lines.
For example,
and receive back dollars at date
foreign specialist were to lend dollars at date
I
charge at the international interest rate of one on this loan. However,
if
1,
if
a
he would
the same specialist
received baht collateral against his loan, then (9) tells he would require a return of e' on his
loan. In the case of contingent credit lines with
(l-n)t h =
Thus,
we
shall interpret e
l
—
1
as the
e
l
=
r
(4 +
premium
0,
the foreign specialist requires that,
ndl).
baht collateral
for lending against
for
a
foreign specialist.
Moving beyond emerging market
for limited insurance
example,
is
it
debt, there seems to be
some theory and evidence
supply in other asset markets leading to high liquidity premia. For
often pointed out that the catastrophe insurance market
is
severely capital
constrained leading to very high insurance premiums and insurance cycles (see Froot and
Some
O'Connell (1997)).
during the
fall
in the
US
credit
LTCM, grew
constrained and became liquidity users as they exited from
23
Given our focus on domestic underdevelopment, we
shall restrict attention to studying a
channel whereby domestic under velopment causes too high a lending premium.
domestic market
is
underdeveloped, foreign specialist entry
lending in the domestic market unprofitable.
may
supply
affect
is
Now
is
phenomena
one plausible avenue through which
a thin market externality. That
is
When
is,
the
also limited, as foreigners find
this
suppose foreign lenders prefer to
lend in a market in which there are already other foreign lenders.
for this
market
of '98 argue that hedge funds which are normally liquidity suppliers to
markets, such as
markets.
meltdown
of the explanations for the
provided in Allen and Gale (1994).
We
A
microeconomic model
defer to their results, and
take a reduced form approach to this issue by positing complementarity in foreign entry
decisions.
24
Suppose that
F
depends on the amount of
F(a)
*""*
= <-
if
23
a >
a.
See Xiong (1999) for an analysis of wealth constrained hedge funds, or Allen and Gale (1994) for a model
with similar
results,
but in a market segmentation, stock market model. See Holmstrom and Tirole (1998)
and Krishnamurthy (2000)
24
entry, so that,
risk that
they
may have
supply in a macroeconomic context.
model must pay a fixed cost to enter the market, and
for limited insurance
Investors in the Allen and Gale (1994)
to liquidate
and
exit the
face the
market. In this instance they prefer that there are other
investors in the market as this increases liquidation values and reduces ex-ante variance of asset prices.
There
is
thus a complementarity between the entry decisions of investors.
25
Figure 2 illustrates the effect of complementarity.
e
1
'
L
V
s
\d
\
'
d
\
\^
\
F
+
+
wf
V
\
F
—
w
\
f
a
Figure
At the low
\
a
the market
sufficiently
\
Complementary Entry Decisions
2:
level of financial
is
\
a
development corresponding to
foreign specialists anticipate little entry by others
if
\
developed
d,
there
is
the possibility that
and stay out of the market. However,
this possibility disappears, as all specialists
(d'),
expect plenty of entry and therefore enter themselves. Contrasting the equilibrium liquidity
premia,
we
see that as A rises
and equilibrium
shifts to d', the
premium charged by
foreign
specialists also falls.
Final
6
We
Remarks
began the paper highlighting an apparent dilemma: Excessive dollarization of private
liabilities
has played a central role in most recent emerging market
this is a private decision,
why
crises.
But given that
don't firms anticipate the dangers and avoid dollar debt?
Our answer began with a motive
to hoard international liquidity: firms experience oc-
casional needs of external resources and the country has only limited access to international
financial markets - moreover, liquidation or limited reinvestment in unfinished projects
is
very costly. Purchasing international insurance against shocks that increase the aggre-
gate ratio of needs to availability of external resources
this liquidity,
implements
The
and issuing debt denominated
in
is
an
efficient
mechanism
to hoard
domestic rather than in foreign currency
this insurance.
reason for underinsurance
lies in
domestic collateral of distressed firms.
another financial market imperfection: the limited
When
26
these constraints are widespread, there
is
restricted competition for available international liquidity, since
insufficient
constrained by
is
domestic collateral rather than by marginal product. In equilibrium, this leads
to a private overvaluation of domestic collateral
other domestic collateral
A
—since
syndrome
is
specialists shrink.
financial
it
is
competition with
it
faces a
of liquidity and
demand
for external
the excessive dollar-indebtedness.
underdevelopment shrinks the
size of the effective international
takes only a step to have also the supply of such liquidity by foreign
Thus supply and demand
In Caballero and Krishnamurthy (2000)
tervention to
little
the insufficient
insurance, and a particular dimension of underinsurance
liquidity market,
is
demand and produce the wrong kind
particular dimension of this
Once domestic
there
— and undervaluation of international liquidity —since
constrained demand. As a result, firms
collateral.
demand
manage the
factors reinforce each other.
we show that
this
environment motivates
international liquidity of a country. However,
attempting to do so within the constraints of
dangerous and policy intervention
may
illiquid
also
show that
domestic financial markets can be
Many
backfire.
we
in-
of the issues and limitations
we
discussed there would apply here as well: in particular, to the question of whether a central
planner should contract contingent external credit lines for the private sector.
Another
issue that arises
is
whether permanently
fixing the
nominal exchange rate solves
the problem by eliminating the need for insurance. At some level the answer to this question
is
obviously no.
rate,
Our
discussion referred to the real rather than the nominal exchange
and the international
domestically mandated one.
liquidity constraint
On
is
a real resource constraint rather than a
the other hand, our current framework
is
not well suited for
addressing such question since our real exchange rate represents a convolution of observed
exchange rates and domestic asset prices (interest
rates).
Different models about goods
markets and the extent and nature of segmentation of the different domestic assets markets
yield different
issue
is
mappings from our framework to nominal exchange
the next step in our agenda.
27
rates.
Addressing this
A
Appendix
A.l
Lemma
Proof of
Take the Lagrangian
L*
for (P5),
W-F
= (l-n){RK +
3
h
)
2A(W-F
n^((R + r)K +
+
- wF +
l
X(c(K)
(1
- n)F
h
)
1
))-
-
^i h
(F h
-W)- W (F
(
- W)
First,
^
dL*
Likewise,
if fih
Where we
=
0, it
= (l- 7r )R + 7T
r
c
would be that,
substituted in A from above and noted that the project
to arrive at the inequality. Since
at date
R+
f^-\
>(K) =
4^
>
0, it
is
must be that
sufficiently profitable
F h = W.
The same
logic applies to the case of (P4).
A. 2
Lemma
Proof of
Consider the
FOC
for
F
l
in (P5),
dL*
OF
4
ir
-—-
+ n\=
1
Given our technical assumptions, this
/' in (P4).
This
Suppose that
^fc) ((1
F =
l
A. 3
A>
e
l
.
Proof of
-
*)
R+
ensure
it
n^^
W>F
This violates the
>
0.
- Ac' (K
Now
consider the
FOC
for
K=
,
FOC,
so
it
fc
)
+ A " *K*\ +
(
df
l
)))
k so that,
dL*
v
must be that
f-
F
>
if
3,
we
will
have that f h
=
f
h
=
Sd
= A—
w. Take the
from (P6):
d6
c '( fc
e
>
0.
7
lemma
For the same logic as in
" Ac '(
n
dL*
Lemma
*^
must be that
l
f then
3C
as long as
will
- n)R +
is,
=
f£
((1
n
l-ir)R + Tr(R--)-eJ'/
c(k)
l
c'{k)
28
.
FOC
for /'
Likewise, from (P4),
dC
W
Suppose that
=
/'
m
=
then
/',
(n
it
must
+
d fi-df
Which can be
A >
For
e
We
/'>/'.
be that k
also
{R
=
—
A+e
r
'
*fn\
c{k)
)
and,
k,
r)+
C
c'(k){2
C{h
2
e'
>)-
rewritten as,
>
l
R+
R+ —2 $
{^-^\i>±
*
both terms
r,
in the parentheses are positive.
could also rewrite this
d
f~df
In this case,
it
must be that
as,
+
C(fc)
c>(k)
This produces the weaker restriction that
2
A>
e
l
e) j-
e^
l
or Sd
>
0,
as well as,
c'(k)-- (r-e )>0,
l
l
e'
which, for example,
is
is
easily satisfied for small
tt,
or
if
the probability of the negative shock
small.
A. 4
Proof of
We
shall
L
=
do
Lemma
this proof in steps. First, consider the
4- f h -t
{l-n){Rk + w +
h
-w)-p {f -w)
h
-
h
-ip
l
(f
-fj.
h
9
(t
-4>((1
-
rk)
-
h
-
n)t
h
Lagrangian
)+n^({R + r^)k-t
l
for (P7),
{l
l
l
l
ip {t
nt
l
-
-
rk)
l
e (d°
$
-X(c(k)-nf -(l-n)f h
L
+
- ir)4 + *ds ))
l
(1
-4)
Then,
R
fir
4-
r—
^r = (l-n)R + ir^^--\c>(k) =
Hence,
1
/
JJ
29
+ r4
+ ^) + {A +
l
e
){w
+
l
ds
-f
1
))
h
Let us start with f
^
where the
f
h
<
w, then
last inequality follows
f
h
Consider t h next.
=
/i
h
=
0.
Suppose
^|(l-
= -(l-^) + A(l- 7r) =
profitable. Hence,
to
If
.
7r)i?
so,
+ 7r^±^-c'(^>0
from the assumption that date
investment
is
sufficiently
w.
If t
h
<
rk then
tp
h
=
First note that,
0.
from the
FOC
with respect
d<jj,
Then,
# = - -)-*|1
Hence we can conclude that
ip
h
|
=?i(t -)B+ '£Ti
>
-H
1
and
t
h
=
rk.
Take d$ next. Assuming the constraint does not bind,
—=
Therefore
it
must be
Finally consider
dj
t'.
(!-„) +
=
e '(i
- tt) =
(1
- T) -
A(l
- tt) <
0.
First note that
H = £(A +
e')
from the
-
vr^e'
FOC
for d$,
= |(A + e <) -
ttA
=
0.
Therefore,
A + e<
.
Now,
~(A + e') <9i'
Hence the firm
is
2
V
4>ix
= - J(A +
2
indifferent over its choice of r.
30
V
e
l
)
+
-ttt
=
0.
0.
>0
-
References
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52 3G
038
mimeo Duke
University, No-
Date Due
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