Research

Abstract: In recent decades, the share of debt denominated in domestic local currency issued by emerging economies has risen sharply—progress away from the “original sin” of issuing sovereign debt exclusively in foreign currencies. Yet, this progress is incomplete and I find that these countries tilt their borrowing towards foreign currency when sovereign risk rises. To study the optimal currency denomination of sovereign debt, I develop a New Keynesian model with sovereign default. I show how the currency denomination of debt is shaped by sovereign risk contingent on fiscal-monetary interactions in default crises, which involve optimal deviations from the inflation target. High levels of local currency debt tempt governments to reduce the debt burden by raising (expected) inflation, which is distortionary. In response, governments tilt the currency denomination of debt towards foreign currency, trading off the consumption hedging benefits of local currency debt, to avoid distortions from rising (expected) inflation. Quantitatively, these trade-offs capture the new evidence, and sovereign risk explains up to 35 percentage points of the share of debt in foreign currency. Optimal debt management reduces inflation, default frequency, and spreads.

Abstract: We build a dynamic model where the economy is vulnerable to belief-driven slow-moving  debt crises at intermediate debt level, and rollover crises at both low and high debt levels. Vis-à-vis the threat of slow-moving crises, countercyclical deficits generally welfare-dominate debt reduction policies. In a recession, optimizing governments only deleverage if debt is close to the threshold below which belief-driven slow-moving crises can no longer occur. The welfare benefits from deleveraging instead dominate if governments are concerned with losing market access even at low debt levels. Long bond maturities may fully eliminate belief-driven rollover crises but not slow-moving ones.