Debauchery and Original Sin: The Currency Composition of Sovereign Debt

Charles Engel and JungJae Park

Journal of the European Economic Association, 2022, vol. 20, issue 3, 1095-1144

Abstract: We present a model that accounts for the “mystery of original sin” and the surge in local-currency borrowing by emerging economies in the recent decade. We quantitatively investigate the currency composition of sovereign debt in the presence of two types of limited enforcement frictions arising from a government's monetary and debt policy: strategic currency debasement and default on sovereign debt. Local-currency debt obligations act as a better consumption hedge against income shocks than foreign-currency debt because their real value can be affected by monetary policy. However, this provides a government with more temptation to deviate from disciplined monetary policy, thus restricting borrowing in local currency more than in foreign currency. Our model predicts that a country with a less credible monetary policy borrows mainly in foreign currency as a substitute for monetary credibility. An important extension demonstrates that in the presence of an expectational Phillips curve, local-currency debt improves the ability of monetary policymakers to commit.

Date: 2022
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Working Paper: Debauchery and Original Sin: The Currency Composition of Sovereign Debt (2018)
Working Paper: Debauchery and Original Sin: The Currency Composition of Sovereign Debt (2018)
Working Paper: Debauchery and Original Sin: The Currency Composition of Sovereign Debt (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:oup:jeurec:v:20:y:2022:i:3:p:1095-1144.

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