The effect of inflation targeting and financial openness on currency composition of sovereign international debt

Abstract

This paper analyzes the joint effect of inflation targeting and capital account openness in promoting changes to the currency composition of sovereign international debt in developing countries. First, using difference-in-differences in combination with entropy balancing, we offer empirical evidence that the adoption of inflation targeting together with high capital account openness can significantly reduce the reliance on foreign currency denominated sovereign international debt. We find that financially integrated inflation-targeting countries have 11 percentage points lower foreign currency shares in their sovereign debt compared to non-targeting countries. Second, we determine the threshold level of financial openness that countries need to attain before they see the full benefits of inflation targeting. Third, the joint effect of inflation targeting and capital account openness significantly increases three years after the policy implementation. Our results are robust to alternative specifications which include instrumental variables to account for the endogeneity of the policy.