Dollarization of Liabilities : Underinsurance and Domestic Financial Underdevelopment

While there is still much disagreement on the causes underlying recent emerging markets' crises, one factor that most observers have agreed upon is that contracting "dollar" (foreign currency) denominated external debt - 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 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 of dollar-debt, complemented with insurance against shocks that depreciate the equilibrium exchange rate. The presence of country-level 'international' financial constraints justify the purchase of such insurance even if all 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