Exchange Rate Policy and Debt Crises in Emerging Economies

Abstract

We explore a model intended to capture the interaction between exchange rate policy, fiscal policy, and outright default on foreign-currency denominated debt. We examine how the exchange rate affects the supply of short-term debt facing the government. We show that under a credible hard peg (currency board), default is a more likely outcome, even without an exceptionally large short-term debt, precisely because a devaluation is not an option. In a more conventional fixed peg, it can be optimal for the government to choose a level of the exchange rate that would be likely to result in partial or complete debt default. Depending on the exchange rate regime, multiple equilibria exist, in one of which the interest rate is high, the exchange rate is overvalued, output is low, and default is high. Under a hard peg, there is a unique equilibrium.Devaluation;External debt;Emerging markets;exchange rate, short-term debt, exchange rate policy, real exchange rate, debt service, debt crisis, exchange rate misalignment, long-term debt, real exchange rate misalignment, debt default, currency board, debt service obligations, sovereign debt, exchange rate overvaluation, currency crises, government debt, exchange rate changes, exchange rate depreciation, debt crises, nominal exchange rate, real exchange rate overvaluation, debt-service obligations, currency crisis, exchange rate peg, debt sustainability, exchange rate regime, exchange rate adjustments, international lending, exchange rate adjustment, public debt, currency risk, external borrowing, debt service payments, public sector debt, amount of debt, balance of payment, exchange rate change, central banks, reserve bank, balance of payment crises, exchange rate mechanism, domestic agent, effective exchange rate, central bank, international debt, debt outstanding, exchange rate flexibility, fixed exchange rate, external shocks, sovereign default, debt problems, overvalued exchange rate, sovereign borrowers, exchange rate policies, debt defaults, real effective exchange rate, exchange rate commitments, currency debt