Financial Innovation in Sovereign Borrowing and Public Provision of Liquidity

Abstract

This paper studies how financial innovation in sovereign debt markets can increase a country’s level of private investment and welfare. I propose a model where public debt has a liquidity purpose for the domestic private sector and is demanded as a saving vehicle by more patient international investors. The public bond is risky, it has a low (high) return when the government’s fiscal capacity is low (high), but the government cannot strategically default on it. The main result of the paper is that the government can increase private investment by increasing the number of assets supplied, tranching its fiscal capacity, and issuing a safe and a risky bond. The risky bond is held only by international investors and the domestic private sector demands the safe bonds. Safe bonds lower the cost of liquidity hoarding for the private sector which enables it to increase investment. I test the predictions of the model using a dataset on public debt and local currency sovereign debt ownership for a group of emerging economies. I find that domestic collateral constraints are key determinants of the shares held abroad of total public debt and especially of relatively riskier debt instruments (local currency debt).