The Currency Composition of Sovereign Debt

The currency composition of sovereign external debt in emerging market economies is tilted towards foreign currency and the share of debt denominated in local currency is highly pro-cyclical. We study these facts through the lens of a quantitative model of optimal currency-composition of sovereign debt when the government lacks commitment regarding monetary policy. High levels of debt in local currency give rise to incentives to dilute debt repayment through nominal currency depreciation. Governments tilt the currency-composition of debt towards foreign currency to avoid the inflationary costs associated with currency depreciation. This is done at the expense of foregoing the hedging properties of debt in local currency. The cyclicality of the currency-composition of sovereign debt responds to the cyclical properties of the benefits associated to debt dilution, which are higher in recessions. Inflation-linked bonds do not eliminate the time inconsistency problem of monetary policy.