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Excessive Dollar Debt: Financial Development and Underinsurance

Author

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  • Ricardo J. Caballero

    (MIT and NBER)

  • Arvind Krishnamurthy

    (Northwestern University)

Abstract

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. Copyright (c) 2003 by the American Finance Association.

Suggested Citation

  • Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, vol. 58(2), pages 867-894, April.
  • Handle: RePEc:bla:jfinan:v:58:y:2003:i:2:p:867-894
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    References listed on IDEAS

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