Sudden Stop with Local Currency Debt

63 Pages Posted: 3 Mar 2021

See all articles by Siming Liu

Siming Liu

Shanghai University of Finance and Economics

Chang Ma

Fudan University - Fanhai International School of Finance (FISF)

Hewei Shen

University of Oklahoma - Department of Economics

Date Written: February 15, 2021

Abstract

Over the past two decades, emerging market economies have improved their external liability structures by increasing the share of debt denominated in local currencies, while foreign currency debt is considered a major source of financial instability. This paper embeds the debt denomination choice in a sudden stop model and explore its implications for the optimal capital control policy. As its payoff depends on the real exchange rate, the local currency debt provides better risk-sharing for emerging market economies but introduces additional distortions. Compared to the competitive equilibrium, a discretionary planner has incentives to deflate the debt burden denominated in local currencies, which increases its issuance cost ex ante. In contrast, a social planner with commitment would promise a higher future payment to obtain a more favorable local currency bond price. Quantitatively, the optimal policy under commitment encourages more borrowing in local currencies, mitigates the severity of crises, and improves welfare relative to the laissez-faire.

Keywords: Sudden Stop, Pecuniary Externality, Local Currency Debt, Time- inconsistency, Capital Control Tax

JEL Classification: F38, F41, G18

Suggested Citation

Liu, Siming and Ma, Chang and Shen, Hewei, Sudden Stop with Local Currency Debt (February 15, 2021). Available at SSRN: https://ssrn.com/abstract=3785755 or http://dx.doi.org/10.2139/ssrn.3785755

Siming Liu

Shanghai University of Finance and Economics ( email )

Shanghai, 200433
China

Chang Ma (Contact Author)

Fudan University - Fanhai International School of Finance (FISF) ( email )

China

Hewei Shen

University of Oklahoma - Department of Economics ( email )

729 Elm Avenue
Norman, OK 73019-2103
United States

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