Monetary Union & Financial Integration - Debt Denominated in Borrower Currency

This paper modifies the model of financial integration linked to exchange rate regimes from Fornaro (2019), by assuming that debt is denominated in the borrower country’s currency rather than lender countries currency. This altered assumption changes the findings of the original model immensely: first, we show that at substantially high levels of debt and elasticity of substitution, the borrower country will always choose to honour its debt, but simultaneously devalue their currency. Therefore, the borrower country never defaults and there are no lending limits imposed by the lender country. Lastly, we show that forming a monetary union is not optimal for a borrower country who can borrow money in local currency. A monetary union will also not lead to higher levels of financial integration and lending capacities. However, we argue that this two-stage game is not realistic, as defaulting or devaluing has no negative impacts on future lending capacities of the borrower country under these assumptions. Therefore, future research could concentrate on adopting the set-up of this model to a multi-stage game in order to allow for credit ”reputation” to play a role in borrowing and lending decisions.