Working Paper: NBER ID: w24671
Authors: Charles Engel; Jungjae Park
Abstract: This study quantitatively investigates the currency composition of sovereign debt in the presence of two types of limited enforcement frictions arising from a government’s monetary and debt policy: strategic currency debasement and default on sovereign debt. Local currency debt obligations are state contingent because the real value can be changed by a government’s monetary policy, and are therefore a better consumption hedge against income shocks than foreign currency debt. However, this higher degree of state contingency for local currency debt provides policymakers with more temptation to deviate from disciplined monetary policy, thus restricting borrowing in local currency more than in foreign currency. The two financial frictions combine to generate an endogenous debt frontier for local and foreign currency debts. Our model predicts that a country with less disciplined monetary policy borrows mainly in foreign currency, as the country faces a tighter borrowing limit for local currency debt than for the foreign currency debt. Our model accounts for the surge in local currency borrowings by emerging economies in the recent decade and the “Mystery of Original Sin”. An important extension demonstrates that in the presence of an expectational Phillips curve, local currency debt improves the ability of monetary policymakers to commit.
Keywords: Sovereign Debt; Currency Composition; Monetary Policy; Emerging Markets
JEL Codes: E52; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| less disciplined monetary policy (E49) | higher reliance on foreign currency borrowing (F65) |
| local currency debt (F34) | better consumption smoothing (D15) |
| temptation to debase (Y60) | restricted borrowing in local currency (H74) |
| enforcement constraints from temptation to debase (P37) | restricted local currency debt (H74) |
| enforcement constraint from option to default (D10) | borrowing limit for foreign currency debt (F34) |