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    Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy
    07 Oct 2016Working Paper Summaries

    Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

    by Wenxin Du, Carolin E. Pflueger, and Jesse Schreger
    This paper explains the relation between sovereign debt portfolios and government bond risks across countries. It demonstrates how the interaction of lender risk aversion and monetary credibility can explain why countries with positive bond-stock betas have the lowest local currency debt share. The framework gives rise to testable predictions on inflation, inflation cyclicality, sovereign debt portfolios, and proxies of effective monetary policy credibility, which the authors verify in the data. Overall, the study contributes to and builds upon the literature of government debt asset pricing.
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    Author Abstract

    Nominal debt provides consumption-smoothing benefits if it can be inflated away during recessions. However, we document empirically that countries with more countercyclical inflation, where nominal debt provides better consumption smoothing, issue more foreign-currency debt. We propose that monetary policy credibility explains the currency composition of sovereign debt and nominal bond risks in the presence of risk-averse investors. In our model, low credibility governments inflate during recessions, generating excessively countercyclical inflation in addition to the standard inflationary bias. With countercyclical inflation, investors require risk premia on nominal debt, making nominal debt issuance costly for low credibility governments. We provide empirical support for this mechanism, showing that countries with higher nominal bond-stock betas have significantly larger nominal bond risk premia and borrow less in local currency.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: September 2016
    • HBS Working Paper Number: NBER Working Paper Series, No. 22592
    • Faculty Unit(s): Business, Government and International Economy
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