Working Paper: NBER ID: w23984
Authors: Luigi Bocola; Guido Lorenzoni
Abstract: Foreign currency borrowing is perceived as a source of financial instability in emerging markets. We propose a theory where liability dollarization arises from an insurance motive of domestic savers. Because financial crises are associated with currency depreciations, savers are reluctant to hold assets denominated in local currency. This behavior makes local currency debt expensive, incentivizing borrowers to issue foreign currency debt. We show that this mechanism can generate multiple equilibria, with the bad equilibrium characterized by dollarization and financial instability. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holdings of foreign currency reserves hedge the fiscal position of the government and enhance its credibility, thus improving financial stability.
Keywords: financial crises; dollarization; lending of last resort; emerging markets
JEL Codes: E44; F34; F41; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| domestic savers' reluctance to hold local currency assets (F31) | increased demand for foreign currency debt (F34) |
| depreciation of local currency (F31) | increased real burden of foreign currency debt (F31) |
| increased real burden of foreign currency debt (F31) | exacerbation of financial instability (F65) |
| government's fiscal credibility (E62) | ability to act as a lender of last resort (E58) |
| foreign currency reserves (F31) | enhancement of government's credibility (H12) |
| government interventions (H53) | reduction of demand for insurance among savers (G52) |
| reduction of demand for insurance among savers (G52) | lower levels of liability dollarization over time (K13) |
| government's capacity to act as a lender of last resort (E58) | elimination of bad equilibrium characterized by high levels of dollarization and financial instability (D53) |
| presence of multiple equilibria (C62) | fragile equilibrium characterized by financial instability and higher excess returns on local currency bonds (F31) |