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Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

Wenxin Du, Carolin E. Pflueger, Jesse Schreger

NBER Working Paper No. 22592
Issued in September 2016, Revised in November 2018
NBER Program(s):Asset Pricing, International Finance and Macroeconomics

We document that governments whose local currency debt provides them with greater hedging benefits actually issue relatively more foreign currency debt. We introduce two features into a government's debt portfolio choice problem to explain this finding: risk- averse lenders and varying degrees of inflation commitment. A government with imperfect commitment chooses an excessively counter-cyclical inflation policy function 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.

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Document Object Identifier (DOI): 10.3386/w22592

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