Essays on the Currency Composition of Sovereign Debt

Fried, Daniel Benjamin, Department of Economics, University of Virginia
Young, Eric, Department of Economics, University of Virginia
Otrok, Chris, Department of Economics, University of Virginia
Taylor, Alan, Department of Economics, University of Virginia
Warnock, Frank, Darden Graduate School of Business, University of Virginia

This dissertationexplores thefactorsthatinfluence a government's decision toborrow inlocalorforeigncurrencies. Thefirstchapterdescribesanewdatasetonthecurrency composition of sovereign debt that is used to identify a variety of factors associated with the share of local currency debt in a government's total sovereign debt portfolio. The second chapter develops a new theory of the optimal currency composition of sovereign debt. In the first chapter of this dissertation a new dataset on sovereign borrowing is compiled by combining extant sovereign debt datasets with newly-acquired data. While developed countries continue to issue a vast majority of their debt in local currency, emerging market economies have seen sizable changes in the denomination of their debt portfolios. Regression results identify two factors strongly linked to high shares of fixed-rate domestic currency sovereign debt for emerging market governments: market size and international reserves. Other variables associated with local currency sovereign borrowing are creditor-friendly institutions, capital controls, reliance on exports and inflation policies. These findings are consistent with the results of past studies of the currency composition of sovereign borrowing. The second chapter develops a theory of the optimal currency composition of sovereign debt. In a model with a micro-founded monetary framework, a government controls monetary policy and has the ability to borrow from abroad using both local and foreign currency bonds. Local currency bonds function as a contingent claim, better allowing governments to smooth consumption. The threat of strategic inflation limits local currency borrowing capabilities. However, a credible monetary policy commitment can eliminate the risk of strategic inflation and improve economic outcomes. In particular, results suggest that adherence to a monetary policy strategy that ameliorates the cost of exchange frictions: 1) improves welfare by a margin equivalent to a permanent 0.05 0ncrease in annual consumption, 2) nearly doubles ii the equilibrium amount of local debt relative to total debt, and 3) increases total sustainable debt levels by nearly 10f GDP.

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PHD (Doctor of Philosophy)
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