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

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.