Equilibrium Foreign Currency Mortgages

IMF Working Papers, March 19, 2021

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The paper proposes a novel explanation for why foreign currency denominated loans to households have become so popular in some emerging economies.
Central argument: the "debt limit channel" arises when multi-period contracts are offered to financially constrained borrowers against collateral that is established on newly acquired assets.
Key mechanism: whenever the difference between domestic and foreign interest rates is positive, the debt limit channel biases borrowers’ choices towards foreign currency, even if the exchange rate is known to depreciate as implied by the interest parity condition.
The paper demonstrates 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.
Comparison to constrained-optimal time-consistent policy shows that a substantial part of the bias towards foreign currency is due to a pecuniary externality: borrowers’ failure to internalize how their currency choice affects collateral prices.

Debt limit channel:
- Operates when multi-period contracts are offered to financially constrained borrowers.
- Collateral is established on newly acquired assets, linking borrowing capacity to asset prices.
- Positive domestic-foreign interest rate differentials increase appeal of foreign currency loans.
Exchange rate risk:
- The bias toward foreign currency persists even when exchange rate is expected to depreciate (as implied by the interest parity condition).
Pecuniary externality:
- Borrowers do not internalize how their currency choice affects collateral prices, amplifying the bias toward foreign currency and contributing to equilibrium dollarization.

The debt limit channel is shown to be quantitatively important in a structural macroeconomic framework.
It can result in dollarization of debt also in the presence of realistic exchange rate risk.
The identified bias towards foreign currency is substantially driven by a pecuniary externality (borrowers' failure to internalize effects on collateral prices).

Recognize the role of the debt limit channel when assessing currency composition of household debt in emerging economies.
Address the pecuniary externality:
- Policies should consider how individual currency choices aggregate to affect collateral prices and systemic dollarization risks.
Design macroprudential and regulatory frameworks that account for multi-period contracts, collateral dynamics, and interest rate differentials to mitigate incentives for foreign currency borrowing.

Subject: Asset and liability management, Currencies, Debt limits, Economic sectors, Financial crises, Financial institutions, Housing, Loans, Money, Mortgages, National accounts
Keywords: biases borrowers' choice, borrowers' failure, Currencies, debt limit channel, Debt limits, equilibrium foreign currency mortgage, foreign currency loan, foreign currency loans, Global, Housing, Loans, mortgages, pecuniary externality, portfolio choice

Marcin Kolasa, "Equilibrium Foreign Currency Mortgages", March 19, 2021.