Decline in the Value of the Domestic Currency

Question

I am using Mishkin's textbook "Economics of Money, Banking and Financial Markets." On the chapter on financial crises, the authors list a number of factors that could trigger a crises.

One factor is An Unanticipated Decline in the Value of the Domestic Currency. I quote "Because of uncertainty about the future value of the domestic currency in developing countries (and in some industrialized countries), many nonfinancial firms, banks, and governments in developing countries find it easier to issue debt denominated in foreign currencies rather than their own currency. This can lead to a financial crisis in a similar fasahion to an unanticipated decline in the price level. With debt contracts denominated in foreign currency when there is an unanticipated decline in the value of the domestic currency, the debt burden of domestic firms increases.• Since assets are typically denominated in domestic currency, there is a resulting deterioration in firms' balance sheets and a decline in net worth, which then increases adverse selection and moral hazard problems along the lines just described."

I don't get the logic. The authors are a bit vague: a decline in the value of the domestic currency perhaps means a depreciation relative to other currencies. Now, if that is correct, if there is uncertainty about the future value of the domestic currency, why would firms issue debt denominated in foreign currencies? If domestic currency is expected to appreciate, then only does it make sense (forgetting uncovered interest parity for now). Am I thinking correctly about this?

Thanks!

Answer 1

Your question appears to be just: why would they issue foreign currency debt?

If an emerging country is growing rapidly, it often attracts capital flows. This is typically associated with a strengthening currency. Firms and investors extrapolate this tendency, and so they lend to the country in the currency of a developed economy (typically the U.S. dollar). If the local currency continues to appreciate against the U.S. dollar, it should be easier to cover the payments (since local currency earnings are worth more). Things break down if this extrapolation fails, as discussed in the question.

In terms of an example, you could look at the developing Asian countries ahead of the Asian Crisis of 1997. Borrowing in U.S. dollars by local forms was the root of the problem. The post-1997 tendency to accumulate large foreign currency reserves by central banks in countries pursuing an export-led growth strategy was a reaction to that experience.