Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy
49 Pages Posted: 7 Feb 2017 Last revised: 13 Jan 2020
Date Written: January 10, 2020
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.
Keywords: local currency debt, bond betas, inflation cyclicality, bond risk premia, inflation commitment
JEL Classification: G12, G15, E3
Suggested Citation: Suggested Citation