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Dollar Denominated Debt and Optimal Security Design

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During a crisis, developing countries regret having issued dollar denominated debt because they have to pay more when they have less. Ex ante, however, they may be worse off issuing local currency debt because the equilibrium interest rate might rise, making it more expensive for them to borrow. Many authors have assumed that lenders and borrowers have contrary goals, and that local currency (peso) debt is better for the borrower (Bolivia), and dollar debt is better for the lender (America). We show that if each country is represented by a single consumer with quadratic utilities, in perfect competition, then both will agree ex ante on whether dollar debt or peso debt is better. (In fact all assets can be Pareto ranked). But we show that it might well be dollar debt that Pareto dominates. In particular, if the lender is sufficiently risk averse and the borrower sufficiently impatient, and the lender's endowment is sufficiently riskless, then dollar debt Pareto dominates peso debt. However, if there are persistent gains to risk sharing between the countries, then peso debt Pareto dominates dollar debt. In the special case where utilities are linear in the first period and quadratic in the second period, we can completely characterize the Pareto ranking of any asset by a formula depending only on marginal utilities at autarky. In the more general case where utilities are linear in the first period and have positive third derivative in the second period, we show that when persistent gains to risk sharing hold, America must gain from Peso debt but Bolivia might lose. Thus the presumption that peso debt is more favorable to Bolivia than to America is false. Our framework of optimal security design can be used to demonstrate one rationale for credit controls. If the purchasing power of a dollar overseas varies with the quantity of debt issued, then both America and Bolivia can gain from capital controls, because a tax that reduces the quantity of Bolivian debt might make the real dollar payoffs in Bolivia more `peso-like', and therefore under persistent gains to risk pooling, better for America and Bolivia.

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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1449.

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Length: 30 pages
Date of creation: Dec 2003
Handle: RePEc:cwl:cwldpp:1449
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  1. berlage, Lodewijk & cassimon, Danny & dreze, Jacques & Reding, Paul, 2003. "Prospective Aid and Indebtedness Relief: A Proposal," World Development, Elsevier, vol. 31(10), pages 1635-1654, October.
  2. van Wincoop, Eric, 1999. "How big are potential welfare gains from international risksharing?," Journal of International Economics, Elsevier, vol. 47(1), pages 109-135, February.
  3. Robert J. Shiller & Stefano Athanasoulis, 1995. "World Income Components: Measuring and Exploiting International Risk Sharing Opportunities," NBER Working Papers 5095, National Bureau of Economic Research, Inc.
  4. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-1089, July.
  5. Demange Gabrielle & Laroque Guy, 1995. "Optimality of Incomplete Markets," Journal of Economic Theory, Elsevier, vol. 65(1), pages 218-232, February.
  6. Bohn, Henning, 1990. "A positive theory of foreign currency debt," Journal of International Economics, Elsevier, vol. 29(3-4), pages 273-292, November.
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