Excessive Dollar Borrowing in Emerging Markets: Balance Sheet Effects and Macroeconomic Externalities

Emerging market economies that borrow in foreign currency are prone to severe financial crises that involve financial amplification, i.e. a feedback loop of depreciating exchange rates, deteriorating balance sheets and declining aggregate demand. This is the first paper to show that such financial amplification effects create an externality that induces individual borrowers to undervalue the social risks of dollar debt and take on too much of it. Specifically, atomistic rational agents take the extent of exchange rate depreciations during crises as given. They realize that foreign currency debt entails large repayments and cut-backs in spending in crisis states, but they do not internalize that the resulting reduction in aggregate demand leads to further depreciations in the exchange rate. These depreciations in turn deteriorate balance sheets and tighten borrowing constraints across the economy, hurting other borrowers. We discuss the merits of various policy measures to correct this distortion and conclude that a reserve requirement on foreign currency debt is the most desirable.