Excessive Dollar Debt: Financial Development and Underinsurance

Authors

  • Ricardo J. Caballero,

  • Arvind Krishnamurthy

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    • Caballero is from MIT and NBER, and Krishnamurthy is from Northwestern University. Caballero thanks the NSF for financial support. We thank Philip Bond, Guillermo Calvo, Bengt Holmstrom, Hugo Hopenhayn, Nisan Langberg, Adriano Rampini, Jean Tirole, and an anonymous referee for comments. We also thank seminar participants at Lacea's Summer Camp in Buenos Aires, MIT, and the University of Rome conference on Information and Business Cycles for comments. We thank Sandra Moore for editorial assistance. All errors are our own.


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 problem.

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