Sudden stop with local currency debt

Abstract

Over the past two decades, emerging market economies have improved their liability structures by increasing the share of their debt denominated in local currency. This paper introduces a local currency debt (i.e., in units of aggregate consumption) into a sudden stop model and explores how this alternative structure sheds new perspectives on financial regulations. Decentralized agents do not internalize the effects of their portfolio decisions on financial amplification and undervalue the insurance benefit of using local currency debt. However, due to debt-deflation incentives and the cost of buying insurance, a discretionary planner is reluctant to issue local currency debts, and capital controls are primarily used to restrict credit volumes. In contrast, a social planner with commitment would promise a higher future payoff to obtain a more favorable bond price. The capital control under commitment encourages borrowing in local currency, mitigates the severity of crises, and improves welfare relative to laissez-faire.