Working Knowledge
Business Research for Business Leaders
17 Nov 2016Working Paper Summaries

Sovereign Risk, Currency Risk, and Corporate Balance Sheets

by Wenxin Du and Jesse Schreger
Why would a country default on its sovereign debt when the government could instead inflate it away? The authors argue that a government is more inclined to default than inflate when the currency mismatch of the corporate sector implies large adverse balance sheet effects from a currency depreciation. To make this argument they construct a dataset on the currency composition of emerging market external borrowing. Results show that the corporate sector relies on external foreign currency debt even as sovereigns have swiftly moved toward borrowing in their own currency.

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

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