Inflation, Default, and the Currency Composition of Sovereign Debt in Emerging Economies: Working Paper 2017-01
In emerging market economies, governments issue debt denominated both in their own currency and in foreign currencies. This paper examines how the use of those two types of debt affects these economies.
In emerging market economies, governments issue debt denominated both in their own currency and in foreign currencies. I develop a theory of the optimal composition of sovereign debt between local and foreign currencies. In a model with a micro-founded monetary framework a government controls monetary policy and has the ability to borrow from abroad using both local and foreign currency bonds. In this model, local currency bonds differ from foreign currency bonds in two important ways. Unlike foreign currency bonds, local currency bonds function as a contingent claim, allowing governments to more easily smooth consumption over time. In addition, the threat of strategic inflation limits the amount that a government can borrow using local currency bonds (but has no direct effect on foreign currency borrowing). When governments can issue both local and foreign currency bonds, equilibrium rates of inflation and national welfare are higher than when the government can issue only foreign currency bonds. In addition, I find that as the cost of default falls, governments choose to issue a larger proportion of debt in their local currency. Compared to monetary regimes that cannot commit to future actions, credible monetary policy commitments can eliminate the risk of strategic inflation and improve economic outcomes.