Research

Abstract: The share of debt denominated in local currency issued by emerging economies has been sharply rising over time—a progress on the road of “graduation from the original sin”. Yet the evidence suggests that the graduation is partial and subject to fluctuations. In this paper, I provide novel evidence that, in a large sample of countries that have adopted inflation targeting, the share of foreign-currency denominated debt is increasing in inflation expectations and default risk. I specify a New Keynesian model with inflationary default risk, where a discretionary government manages the currency denomination of debt trading off containing distortionary inflation via foreign currency debt with hedging consumption via local currency debt. Quantitatively, anticipations of inflationary default explain up to 37% of the share of borrowing in foreign currency. Optimal debt management contains 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.

Abstract: We develop a model where optimizing governments hold reserves with the goal of reducing their country’s vulnerability to belief-driven sovereign risk crises. As in Aguiar, Chatterjee, Cole, and Stangebye (2022), such vulnerability stems from post-auction uncertainty about repayment. We show that accumulating reserves can eliminate such uncertainty, thereby allowing governments to issue debt along the fundamental price schedule and improve inter-temporal consumption smoothing. Our analysis helps to explain why governments hold significant amounts of reserves without consuming them substantially in economic downturns—quantitatively, up to 3.0% of GDP if debt is short term, or 2.2% if debt maturity is long.