Liability Dollarization, Sudden Stops & Optimal Financial Policy

Abstract

Banks in emerging markets intermediate capital inflows denominated in hard currencies (i.e. tradable goods) to fund loans denominated in domestic currency (i.e. domestic consumption units). This “liability dollarization” affects borrowing decisions via three effects absent from standard Sudden Stops models, in which domestic loans are in units of tradables. First, real depreciations reduce ex-post real interest rates, and hence the burden of repaying outstanding debt. Second, expected real appreciations reduce ex-ante real interest rates and increase the resources generated by issuing new debt. Third, the positive co-movement of consumption and real interest rates reduces the expected marginal cost of borrowing. These effects add an “intermediation externality” to the macroprudential externality of the standard models. Optimal policy under commitment is time-inconsistent, tightens access to debt when expectations of real appreciation rise, and does not require capital controls. In contrast, an optimal, time-consistent policy requires both domestic credit regulation and capital controls. Quantitatively, the model predicts higher debt ratios with milder Sudden Stops than the standard models, but it fits observed Sudden Stops better. The optimal policy is very effective but also complex, while simple rules optimized to maximize welfare are much less effective, and implemented with ad-hoc values can reduce welfare significantly. Welfare-improving policies favor taxing domestic debt more than capital inflows, and subsidizing inflows is part of the optimal policy.