COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1449

Dollar Denominated Debt and Optimal Security Design

John Geanakoplos and Felix Kubler

December 2003

During a crisis, developing countries regret having issued dollar denominated debt because they have to pay more when they have less. Ex ante, however, they may be worse off issuing local currency debt because the equilibrium interest rate might rise, making it more expensive for them to borrow. Many authors have assumed that lenders and borrowers have contrary goals, and that local currency (peso) debt is better for the borrower (Bolivia), and dollar debt is better for the lender (America).

We show that if each country is represented by a single consumer with quadratic utilities, in perfect competition, then both will agree ex ante on whether dollar debt or peso debt is better. (In fact all assets can be Pareto ranked). But we show that it might well be dollar debt that Pareto dominates. In particular, if the lender is sufficiently risk averse and the borrower sufficiently impatient, and the lender's endowment is sufficiently riskless, then dollar debt Pareto dominates peso debt. However, if there are persistent gains to risk sharing between the countries, then peso debt Pareto dominates dollar debt.

In the special case where utilities are linear in the first period and quadratic in the second period, we can completely characterize the Pareto ranking of any asset by a formula depending only on marginal utilities at autarky.

In the more general case where utilities are linear in the first period and have positive third derivative in the second period, we show that when persistent gains to risk sharing hold, America must gain from Peso debt but Bolivia might lose. Thus the presumption that peso debt is more favorable to Bolivia than to America is false.

Our framework of optimal security design can be used to demonstrate one rationale for credit controls. If the purchasing power of a dollar overseas varies with the quantity of debt issued, then both America and Bolivia can gain from capital controls, because a tax that reduces the quantity of Bolivian debt might make the real dollar payoffs in Bolivia more `peso-like', and therefore under persistent gains to risk pooling, better for America and Bolivia.

Keywords: Dollar debt, Currency, Indexed bonds, Security design, Capital controls

JEL Classification: D61, F31, F34, G10, G12