Sovereign Risk, Expected Inflation, and the Currency Denomination of Sovereign Debt
This paper studies optimal debtmanagement by currency in inflation-targeting emerging countries. First, I document new evidence that these countries tilt their borrowing towards foreign currency when sovereign risk rises. Second, I develop a New Keynesian model with sovereign default, and show how the currency denomination of debt is shaped by sovereign risk contingent on fiscal-monetary interactions in default crises, which involve optimal deviations from the inflation target. Local currency debt hedges consumption fluctuations, while foreign currency debt reduces governments’ incentive to raise (expected) inflation that generates distortions. Quantitatively, these tradeoffs capture the new evidence and explain up to 35 percentage points of the foreign currency debt share. Optimal debt management reduces inflation, default frequency, and spreads.
