Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy
46 Pages Posted: 7 Sep 2016
Date Written: September 2016
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 counter-cyclical 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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