The macroeconomic consequences of carry trade gone wrong and borrower protection

Emerging Europe enjoyed massive capital inflows prior to the Great Financial Crisis, but these came to a sudden stop in 2008. This rapid reversal of fortunes created a major macroeconomic slowdown across the region. Moreover, accumulated debt and especially foreign currency debt became the undesirable legacy of these credit inflows. How countries in Emerging Europe coped with foreign currency debt during the ensuing recession and whether they could have done better is the main topic of this thesis. In contrast to the traditional approach, the thesis pays attention to household borrowing in addition to corporate borrowing, because households often borrowed in foreign currency even more actively than businesses. The thesis develops a model to account for corporate debt overhang in line with the finance literature (Merton (1974)) and uses calibration and Bayesian estimation techniques to make the model represent the sharp depreciation episode in Hungary in 2009. Using this model, the thesis shows that insulating corporate borrowers from exchange rate risk and landing losses to banks results in better macroeconomic outcomes. However, foreign currency mortgages to households generate less recessionary outcomes than currency mismatch in the banking sector. Finally, the thesis focuses on the macroeconomic implications of household bankruptcy, regardless of currency denomination. It shows that increasing borrower protection, namely decreasing lender recourse, brings ex-ante macroeconomic and welfare benefits.