Sovereign Risk, Currency Risk, and Corporate Balance Sheets

Jesse Schreger and Wenxin Du

Working Paper from Harvard University OpenScholar

Abstract: We examine the question of why a government would default on debt denominated in its own currency. Using a newly constructed dataset of 14 emerging markets, we document that the private sector continues to borrow from abroad in foreign currency while sovereigns increasingly borrow from foreigners in local currency. Because depreciation can be very costly for a corporate sector with a currency mismatch due to foreign currency liabilities, emerging market sovereigns may still prefer to default on local currency sovereign debt rather than inflate the debt away. Using our cross-country dataset, we show that a higher reliance on external foreign currency corporate financing is associated with a higher default risk on sovereign debt. We quantify the effects of corporate balance sheet mismatch on sovereign credit risk by introducing local currency sovereign debt and private currency mismatch into a standard sovereign debt model. The model demonstrates how the currency composition of corporate borrowing affects the sovereign's incentive to inflate or default in times of fiscal stress. Reductions in the share of private external debt in foreign currency can lead to significant reductions in sovereign default risk. A calibration of the model generates the empirical patterns of currency and credit risk in local currency sovereign debt documented in Du and Schreger (2014).

Date: 2014-10
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Persistent link: https://EconPapers.repec.org/RePEc:qsh:wpaper:209056

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