The Optimal Currency Composition of External Debt: Theory and Applications to Mexico and Brazil

Abstract

The changes in exchange rates, interest rates, and commodity prices during the past decades have had large impacts on developing countries. Many developing countries have limited access to already incomplete international long-term hedging markets. Thus the question arises whether the currency composition of external debt can be used to minimize exposures to external price risk. Using a utility-maximizing framework, this article shows that, by choosing the optimal currency composition, a country can indeed manage its external exposure. The optimal, risk-minimizing currency composition depends on the relation between export receipts and the costs of borrowings in each currency and on the relations among the costs of borrowings in different currencies. A simple methodology can be used to derive the optimal shares of individual currencies and is applied to Mexico and Brazil. The results show that Mexico and Brazil could have lowered their external exposure to a limited degree by continuously alternating the currency composition of their debts. The low correlations between the costs of borrowings and export and import prices make the currency composition of debt a very imperfect hedging tool, and it is likely that hedging instruments directly linked to prices are preferable.