TY - JOUR AU - Caballero,Ricardo J. AU - Krishnamurthy,Arvind TI - Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment JF - National Bureau of Economic Research Working Paper Series VL - No. 7792 PY - 2000 Y2 - July 2000 UR - http://www.nber.org/papers/w7792 L1 - http://www.nber.org/papers/w7792.pdf N1 - Author contact info: Ricardo J. Caballero MIT Department of Economics Room E52-373a Cambridge, MA 02142-1347 Tel: 617/253-0489 Fax: 617/253-6915 E-Mail: caball@mit.edu Arvind Krishnamurthy Kellogg School of Management Northwestern University 2001 Sheridan Road Evanston, IL 60208 Tel: 847/491-2671 Fax: 847/491-5719 E-Mail: a-krishnamurthy@northwestern.edu AB - 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. ER -