Dollarization of liabilities and the value of collateral

Heavy reliance on dollar denominated debt appears to have been one of the reasons that the East Asian financial crisis had severe real effects. In the model presented in this paper severe mismatch between dollar denominated debt and domestic currency revenues of firms may occur. The explanation is based on the possibility that it is relatively less costly to enter bankruptcy if many other firms in the same country are bankrupt. This possibility depends on two key assumptions, that national characteristics make it very difficult for foreigners to manage firms in the country and that the capacity even of domestic firms to effectively expand via mergers and acquisitions is limited. In the model creditors are fully rational. To reconcile the large observed losses of creditors with rationality, it is assumed that debtors actions depend on a sunspot. Thus widespread balance sheet miss-match might or might not develop. Much simpler models can explain the observed experience of firms in East Asian countries and their creditors if creditors are irrational.