Equilibrium foreign currency mortgages

Abstract This paper proposes a novel explanation for why foreign currency denominated loans to households have become so popular in some emerging economies. Our argument is based on what we call the debt limit channel, which arises when multi-period contracts are offered against collateral that is established on newly acquired assets. Whenever the difference between domestic and foreign interest rates is positive, this effect allows financially constrained agents to backload the real payments on their loans if they choose to borrow in foreign currency. We demonstrate in a structural macroeconomic framework that the debt limit channel is quantitatively important and can result in dollarization of debt despite realistic and correctly perceived exchange rate risk. Comparing this outcome to allocations under constrained-optimal policy reveals that much of the identified bias towards foreign currency is due to a pecuniary externality, i.e. borrowers' failure to internalize how their currency choice affects house prices.