Equilibrium Foreign Currency Mortgages

Marcin Kolasa

No 2021/084, IMF Working Papers from International Monetary Fund

Abstract: 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 structural macroeconomic framework that the debt limit channel is quantitatively important and can result in dollarization of debt also in the presence of realistic exchange rate risk. Comparing this outcome to allocations under constrained-optimal time-consistent policy reveals that a substantial part of the identified bias towards foreign currency is due to a pecuniary externality, i.e. borrowers’ failure to internalize how their currency choice affects collateral prices.

Keywords: foreign currency loans; mortgages; portfolio choice; pecuniary externality; equilibrium foreign currency mortgage; debt limit channel; borrowers' failure; biases borrowers' choice; foreign currency loan; Currencies; Debt limits; Loans; Housing; Global (search for similar items in EconPapers)
Pages: 42
Date: 2021-03-19
New Economics Papers: this item is included in nep-dge
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Related works:
Journal Article: Equilibrium foreign currency mortgages (2022)
Working Paper: Equilibrium foreign currency mortgages (2018)
Working Paper: Equilibrium foreign currency mortgages (2016)
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