Equilibrium foreign currency mortgages

This paper proposes a novel explanation for why foreign currency denominated loansto households have become so popular in some emerging economies. Our argument isbased on what we call the debt limit channel, which arises when multi-period contractsare offered to financially constrained borrowers against collateral that is established onnewly acquired assets. Whenever the difference between domestic and foreign interestrates is positive, this channel biases borrowers' choices towards foreign currency, evenif the exchange rate is known to depreciate as implied by the interest parity condition.We next use a small open economy DSGE model to analyze how the debt limit channelaffects agents' choices under uncertainty. The model implies that, if first-order effectsrelated to the debt limit channel are neutralized by appropriate adjustment in debtcontracts, the equilibrium share of foreign currency loans is small.