Sudden Stop with Local Currency Debt

Abstract

Over the past two decades, emerging market economies have improved their external liability structures by increasing the share of debt denominated in local currencies, while foreign currency debt is considered a major source of financial instability. This paper embeds the debt denomination choice in a sudden stop model and explore its implications for the optimal capital control policy. As its payoff depends on the real exchange rate, the local currency debt provides better risk-sharing for emerging market economies but introduces additional distortions. Compared to the competitive equilibrium, a discretionary planner has incentives to deflate the debt burden denominated in local currencies, which increases its issuance cost ex ante. In contrast, a social planner with commitment would promise a higher future payment to obtain a more favorable local currency bond price. Quantitatively, the optimal policy under commitment encourages more borrowing in local currencies, mitigates the severity of crises, and improves welfare relative to the laissez-faire.