Debauchery and Original Sin: The Currency Composition of Sovereign Debt

Charles Engel and Jungjae Park ()
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Jungjae Park: National University of Singapore

No GRU_2018_008, GRU Working Paper Series from City University of Hong Kong, Department of Economics and Finance, Global Research Unit

Abstract: This study quantitatively investigates 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 are state contingent in that the real value can be changed by a government’s monetary policy. It thus acts as a better consumption hedge against income shocks than foreign currency debt. However, this higher degree of state contingency for local currency debt provides a government with more temptation to deviate from disciplined monetary policy, thus restricting borrowing in local currency more than in foreign currency. The two financial frictions related to the two limited enforcement problems combine to generate an endogenous debt frontier for local and foreign currency debts. Our model predicts that a less disciplined country in terms of monetary policy borrows mainly in foreign currency, as the country faces a much tighter borrowing limit for local currency debt than for the foreign currency debt. Our model accounts for the surge in local currency borrowings by emerging economies in the recent decade and the “Mystery of Original Sin”. An important extension demonstrates that in the presence of an expectational Phillips curve, local currency debt improves the ability of monetary policymakers to commit.

JEL-codes: E32 E44 F34 (search for similar items in EconPapers)
Pages: 61 pages
Date: 2018-06-06
New Economics Papers: this item is included in nep-mac and nep-sea
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https://www.cb.cityu.edu.hk/ef/doc/GRU/WPS/GRU%232018-008%20Engel.pdf (application/pdf)

Related works:
Journal Article: Debauchery and Original Sin: The Currency Composition of Sovereign Debt (2022)
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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