Limited Participation and Local Currency Sovereign Debt

Abstract

Governments in emerging countries are increasingly issuing bonds in local currencies and foreign holdings of these bonds have been growing significantly. Motivated by these novel facts, we build a model where local (foreign) investors specialize in local (foreign) currency bonds. After paying a fee, foreign investors can also buy local currency bonds. Based on recent low U.S. interest rates, the model predicts the documented increase in foreign holdings and correlation between local and foreign currency bond returns, and spillovers of foreign shocks to local markets. Higher expected future U.S. interest rates imply sharp reductions in foreign holdings.

Keywords: local currency, emerging countries, limited arbitrage, market segmentation

JEL Classification: E43, G12, F31, G11