International bond risk premia, currency of denomination, and macroeconomic (in)stability

• Author: Shu‐Hua Chen
• DOI: http://doi.org/10.1111/jpet.12333
• Date: 01 December 2018
• Published date: 01 December 2018

Received: 29 October 2017

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Revised: 18 August 2018

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Accepted: 18 August 2018

DOI: 10.1111/jpet.12333

ORIGINAL ARTICLE

International bond risk premia, currency of

denomination, and macroeconomic (in)stability

Shu‐Hua Chen

Department of Economics, National Taipei

University, New Taipei City, Taiwan

Correspondence

Shu‐Hua Chen, Department of Economics,

National Taipei University, 151 University

Road, San Shia District, New Taipei

City 23741, Taiwan.

Email: shchen@mail.ntpu.edu.tw

Funding information

Ministry of Science and Technology, Taiwan,

Grant/Award Number: MOST 105‐2410‐H‐

305‐003‐MY3

Abstract

I show that, in real small‐open as well as large‐open economies,

international borrowing produces a destabilizing effect that

significantly lowers the minimum level of increasing returns to

scale needed for indeterminacy. In this case, a sufficiently high

debt‐to‐capital ratio coefficient in the borrowing rate schedule

operates like an automatic stabilizer that mitigates belief‐driven

cyclical fluctuations. The analysis conducted within the mone-

tary setting shows that both the benchmark nominal interest

rate and the inflation rate of the country of the denominated

currency may lessen the destabilizing effect of international

borrowing. When domestic sunspot shocks exert sufficiently

strong effects on these two variables, international borrowing

may instead stabilize the domestic economy. I also find that

inflation indexed bonds remove the stabilizing effect of the

inflation rate of the country of the denominated currency and

make different types of international bonds under different

monetary regimes exhibit qualitatively the same destabilizing

effect as real bonds in real economies. In addition, flexible

inflation targeting performs no worse than rigid inflation

targeting in all cases. Finally, the quantitative analysis under-

taken shows that in the past few decades the considerable

increase in foreign indebtedness may have destabilized the U.S.

economy by giving rise to belief‐driven fluctuations.

KEYWORDS

currency of denomination, equilibrium (in)determinacy, interna-

tional bond risk premia, open economies

JEL CLASSIFICATION

E32, E52, F34, F41

J Public Econ Theory. 2018;20:795–821. © 2018 Wiley Periodicals, Inc.

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INTRODUCTION

The last few decades have witnessed remarkable growth in international capital markets. Many countries have

liberalized their bond market, thus making debt instruments more liquid and more accessible to international

borrowers and investors. The international bond market consists of two segments: foreign bonds and Eurobonds.

Before the 1980s, private entities in both industrial and developing countries raised needed funds in the

international bond market mainly through issuances of foreign bonds, which are international bonds issued in a

foreign country and denominated in that country’s currency. Eurobonds, first issued in 1963 in London for a loan of

US$15 million for the Italian Autostrade, are international bonds denominated in a currency (or more than one

currency) not native to the country where they are sold. Since the 1980s, the Eurobond market has become bigger

than the foreign bond market. The rapid growth of the Eurobond market is a result of the progress in technological

development, the globalization of financial markets, and especially due to the relative advantages of Eurobonds

over foreign bonds.

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In spite of the importance of the international bond market as a source of raising needed funds, there still lacks

an exploration of the relative performance of foreign bonds versus Eurobonds as instruments by which domestic

agents raise international funds. The main purpose of this paper is thus to explore how the issuances of foreign

bonds and Eurobonds affect an open indebted country’s aggregate stability. As it turns out, four factors are crucial

in the interrelations between international bonds and equilibrium (in)determinacy: (a) the debt‐to‐capital ratio

coefficient in the borrowing rate schedule, which reflects the sensitivity of the risk premium to a change in the

borrower’s credit quality; (b) the type and details of international bonds, including the reference benchmark

interest rate and currency of denomination; (c) the monetary regime adopted; and (d) the degree of productive

externalities.

I start with analyzing a small‐open‐economy (SOE) extension of Benhabib and Farmer’s (1994) closed‐economy

one‐sector real business cycle (RBC) model under aggregate increasing returns; the study within a real SOE enables

me to focus on the role of risk premia. Domestic private agents have access to an imperfect world capital market to

borrow internationally by issuing international bonds. The interest rate charged on the international bonds includes

a household‐specific risk premium that increases with the household’s debt‐to‐capital ratio. Specifically, as

indebtedness increases, so does the default risk and hence the risk premium needed to compensate the lenders.

Such a linkage between the risk premium and the household’s debt‐to‐capital ratio can be motivated by the

literature on collateral constraint (Kiyotaki & Moore, 1997) and/or that on optimal contracts under costly state

verification (Bernanke, Gertler & Gilchrist, 1999). As a result, households take into account the way in which their

credit quality affects the borrowing rate.

The analysis carried out within this real SOE shows that international borrowing creates a destabilizing effect

that significantly lowers the threshold value of productive externalities above which belief‐driven business

fluctuations occur. First, start the economy from its steady state. When agents expect an expansion of future

economic activities, they will sacrifice current consumption for capital investment. As in Benhabib and Farmer’s

(1994) closed economy, the subsequent increase in both capital stock and labor employment derives for households

an increased real return on capital. Moreover, in this paper’s open economy the increased capital stock also

influences the marginal benefit and cost of international borrowing, thereby inducing households to borrow from

the international capital market by issuing international bonds. The international funds thereby raised are injected

into the economy in the form of capital investment and hence derive for the household an additional real return on

capital. Because of the additional increases in the return on capital produced by international borrowing, agents’

initial expectations of a higher rate of return on capital are validated under a degree of externalities that is strictly

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The Eurobond market is external and supernational by nature and is not subject to the regulations of the country of currency denomination and also the

countries where they are sold. This makes issuances faster and more economical and the size of funding much larger as well. Moreover, Eurobonds are

issued in bearer form, and the bond holders are not subject to paying taxes. This makes Eurobonds more attractive to investors.

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