Financial Instability under Floating Exchange Rates

At the end of the nineties, many developing countries featured an open capital market and relied heavily on dollar-debt financing of their economy. This paper analyses whether, in this context, clean floating can be a sustainable policy choice. The model is cast as a game between successive generations of investors who decide whether they buy or not the debt of a representative firm. The exchange rate is subject to random shocks, which makes uncertain the private sector’s solvency. We show that a small risk of insolvency would bring about a much larger risk of illiquidity. A rational expectation equilibrium without default can be put forward only in the highly improbable case when the currency is extremely overvalued. The case against flexible exchange rates may be stronger than usually thought.