Geopolitical Fragmentation, Sovereign Debt, and Dollar Dominance

Countries borrow in dollars because dollar debt markets are deep and liquid. This paper develops a theory of when that dominance becomes fragile because countries have inherited dollar liabilities but increasingly earn yuan-linked revenues. In the model, countries begin with dollar-denominated sovereign debt. Geopolitical fragmentation raises their yuan revenue share through two channels: higher trade barriers with dollar-linked markets shift exports toward yuan-linked markets, and higher costs of using dollars in that trade make yuan settlement more attractive. Governments then face a choice: repay dollar debt using revenues that are less dollar-linked, default, or restructure into yuan. The paper identifies a liquidity spillover from restructuring: dollar-to-yuan restructurings deepen yuan debt markets, lowering refinancing costs and encouraging additional restructurings. The model shows when fragmentation produces limited restructuring and when it triggers a self-reinforcing shift from dollar debt to yuan debt. A cascade requires the liquidity feedback from yuan restructuring to be stronger than the dispersion in countries’ yuan revenue exposure.