On the Dynamic Capital Structure of Nations: Theory and Empirics

Abstract

We analyze the optimal capital structure of a nation from a corporate finance perspective. In particular, we draw an analogy between a nation's fiat money and corporate equity following Bolton and Huang (2018). Based on dynamic capital structure theory, we develop a stochastic model to determine the optimal combination of fiat money and foreign-currency debt used by a nation to fund its investments. The optimal capital structure of a nation depends on the trade-off between the inflation risk of fiat money and the default risk of foreign-currency debt. Introducing outstanding debt to our model sheds light on how a nation dynamically adjusts its capital structure over time. Based on an analysis of 22 emerging economies, the empirical results support our theoretical model of the capital structure of a nation.

Keywords: Dynamic Capital Structure, Fiat Money, Foreign-Currency Debt, Stochastic Model, Inflation Risk, Default Risk

JEL Classification: E22, E31, E41, F34, G32