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Overcoming the Original Sin: gains from local currency external debt

Ricardo Sabbadini

No 484, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: Is it better for emerging countries to issue external debt denominated in local (LC) or foreign currency (FC)? An economy issuing LC debt can avoid an explicit and costly default by inflating away its debt. However, in the hands of a discretionary policymaker, such tool might lead to excessive inflation and negative consequences for welfare. To investigate this question, I develop a quantitative model of sovereign default extended to incorporate real exchange rates and inflation. I find that an economy issuing LC debt defaults less often, sustains slightly lower debt levels, and presents positive average inflation. The net effect is a modest welfare loss when compared to issuing debt in FC. However, if monetary policy is credible, the welfare change is positive, but also of limited size. In this case, the real exchange rate serves as a buffer to accommodate negative output shocks and to prevent defaults

New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-opm
Date: 2018-09
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