Excessive Dollar Debt: Financial Development and Underinsurance

Excessive Dollar Debt: Financial Development and Underinsurance

By
Ricardo J. Caballero, Arvind Krishnamurthy
The Journal of Finance. April
2003, Vol. 58, Issue 2, Pages 867-894

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.