Abstract

We document that governments whose local currency debt provides them with greater hedging benefits actually issue relatively more foreign currency debt. We introduce two features into a government's debt portfolio choice problem to explain this finding: risk-averse lenders and varying degrees of inflation commitment. A government with imperfect commitment chooses an excessively counter-cyclical inflation policy function 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." Columbia Business School, October 2018.

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