Dollar Debt in Developing Countries: Too Much of a Good Thing?

In the early 2000s, many developing countries in Eastern Europe, Latin America and Asia presented substantial corporate dollar debts. This paper suggests an explanation for this worrisome phenomenon, which builds on the traditional signaling approach. The model brings into the picture specific institutional characteristics of the credit market in these countries. If lenders have no direct possibility to infer a firm's financial status, sound firms might want to borrow dollars and bear a high clearance cost -- connected to the grant procedure -- just in order to signal their type. The success of this policy depends on the behavior of bad firms. When dollar borrowing clearance costs are relatively small with respect to the clearance cost of borrowing in the local currency, the whole corporate sector would opt for liability dollarization. In this most inefficient case, the signaling effect vanishes, while all firms bear high clearance costs. We also put forward the necessary conditions for a separating equilibrium to occur.