Equilibrium Foreign Currency Mortgages

This paper proposes a novel explanation for why foreign currency denominated loans to households have become so popular in some emerging economies. Our argument is based on what we call the debt limit channel, which arises when multi-period contracts are offered to financially constrained borrowers against collateral that is established on newly acquired assets. Whenever the difference between domestic and foreign interest rates is positive, this effect biases borrowers’ choices towards foreign currency, even if the exchange rate is known to depreciate as implied by the interest parity condition. We demonstrate in a structural macroeconomic framework that the debt limit channel is quantitatively important and can result in dollarization of debt also in the presence of realistic exchange rate risk. Comparing this outcome to allocations under constrained-optimal time-consistent policy reveals that a substantial part of the identified bias towards foreign currency is due to a pecuniary externality, i.e. borrowers’ failure to internalize how their currency choice affects collateral prices.