Firms’ Financing, Contract Enforcement, and Liability Dollarization

Abstract

This paper analyzes how the presence of liability dollarization, different degrees of contract enforcement, and the possibility to default on debts affect firms’ financing decisions. The framework is a dynamic model of heterogeneous firms. They finance their capital acquisitions using their own income and borrowing from foreign lenders. The set of contracts available incorporates the possibility of default. The incentives to repay or default are determined by the firms’ value relative to the value of default, controlled by the degree of contract enforcement and the presence of liability dollarization. Quantitative evidence is found to support the common wisdom that firms in economies subject to liability dollarization are more likely to default. The presence of liability dollarization increases the likelihood of default by 13%. Weak contract enforcement increases the probability of default by almost 19%. Default regions are determined, with small, highly leveraged firms being more prone to default.