Working Paper: NBER ID: w22592
Authors: Wenxin Du; Carolin E. Pflueger; Jesse Schreger
Abstract: 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: Sovereign Debt; Monetary Policy; Risk Premiums
JEL Codes: E4; F3; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Local currency debt hedging benefits (F31) | Increased foreign currency borrowing (F65) |
| Lack of monetary policy commitment (E49) | Excessive countercyclical inflation (E31) |
| Excessive countercyclical inflation (E31) | Increased risk premiums demanded by lenders (G21) |
| Increased risk premiums demanded by lenders (G21) | Local currency debt becoming prohibitively expensive (F31) |
| Lack of monetary policy commitment (E49) | Increased foreign currency borrowing (F65) |