Lewei He

I develop a theory of exchange rates in which currency-mismatched firms finance an economy's dollar demand. Firms respond to uncovered interest parity (UIP) premia by issuing defaultable dollar debt, but additional issuance raises default risk and lowers bond prices. This credit-risk price impact limits arbitrage and sustains a premium that widens with leverage. Depreciation raises debt burdens, reinforcing the feedback between borrowing capacity and exchange rates. This price-impact view helps account for several longstanding puzzles in exchange-rate dynamics and capital flows. The mechanism applies wherever currency-mismatched borrowers channel foreign funding. Evidence from ten Asian economies shows strong comovement between UIP premia and corporate spreads. Wider premia induce more corporate dollar issuance alongside higher credit risk and borrowing costs. Higher interest differentials predict less depreciation when corporate credit is weak, and accumulated debt predicts depreciation at horizons consistent with maturity. The model also has implications for financial stability: short debt maturity and shallow currency markets raise sudden-stop risk. Firms overborrow because each ignores its exchange-rate effect on others; a state-contingent inflow tax improves welfare.