By Marcin Kolasa
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 simple macroeconomic framework that the debt limit channel is quantitatively important and can result in dollarization of debt also when borrowing in foreign currency is risky. We next use a small open economy DSGE model and show that, if first-order effects related to the debt limit channel are neutralized by appropriate adjustment in debt contracts, the equilibrium share of foreign currency loans is small.
I think the point of the paper is that mortgage holders in countries with a currency that depreciates (and thus has a higher interest rate) borrow in a foreign currency so that they can borrow more. This is reminiscent of balloon mortgages in the US. Do the borrowers really know what they are getting into? Do the lenders realize that the borrowers are likely facing difficulties?