Abstract

We document that governments whose local currency debt provides them with greater hedging benefits actually borrow more in foreign currency. We introduce two features into a government’s debt portfolio choice problem to explain this finding: risk-averse lenders and lack of monetary policy commitment. A government without commitment chooses excessively countercyclical inflation ex post, which leads risk-averse lenders to require a risk premium ex ante. This makes local currency debt too expensive from the government’s perspective and thereby discourages the government from borrowing in its own currency.

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Citation

Du, Wenxin, Carolin Pflueger, and Jesse Schreger. "Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy." Journal of Finance 75, no. 6 (December 2020): 3097-3138.

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