Currency and Capital in Emerging and Developing Economies

Abstract

This thesis studies the role of currency in shaping capital flows to and investment in emerging and developing economies. Chapter 1 proposes a novel trade-off for emerging-market sovereign borrowing. Borrowing in local currency insulates sovereigns from default but increases the severity of bond fire sales in bad times, as local-currency bonds are endogenously held by intermediaries vulnerable to fire sales. We present two facts about intermediary sorting and causal evidence of local-currency fire sales. We rationalize the facts in a model where foreign households demand money-like claims denominated in their own currency from intermediaries, and study the optimal currency composition of sovereign debt. Chapter 2 studies the macroeconomic implications of widespread dollar lending in a small open economy. Using microdata from Peru, we document widespread dollar exposure across the firm size, leverage, and sectoral distribution. We develop a model to characterize currency depreciations given this heterogeneity. Aggregate outcomes following a depreciation depend on the joint distribution of firms’ exposures and their marginal propensities to invest out of liquidity, which are particularly high for some firms. Estimating the model on the universe of firms, we find that depreciations are significantly more contractionary than predicted by representative-firm models. Chapter 3 introduces a theory wherein dollarization arises as a risk transfer between domestic firms and households, who hedge against inflation and income risks from local currency depreciations. We use cross-country and household-level data from Uruguay to test the predictions of the model. We evaluate the effectiveness of capital controls in this setting, and find that they can have perverse effects.