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

• Date: 01 December 2020
• Author: JESSE SCHREGER,CAROLIN E. PFLUEGER,WENXIN DU
• Published date: 01 December 2020
• DOI: http://doi.org/10.1111/jofi.12965

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 6 •DECEMBER 2020

Sovereign Debt Portfolios, Bond Risks, and the

Credibility of Monetary Policy

WENXIN DU, CAROLIN E. PFLUEGER, and JESSE SCHREGER∗

ABSTRACT

Wedocument that governments whose local currency debt provides them with greater

hedging benefits actually borrow more in foreign currency.We introduce two features

into a government’s debt portfolio choice problem to explain this finding: risk-averse

lenders and lack of monetary policy commitment. A government without commitment

chooses excessively countercyclical inflation ex post, which leads risk-averse lenders

to require a risk premium ex ante. This makes local currency debt too expensive from

the government’s perspective and thereby discourages the government from borrow-

inginitsowncurrency.

HOW SHOULD GOVERNMENTS FINANCE THEIR deficits? A long-standing liter-

ature argues that governments should borrow using state-contingent debt to

smooth fluctuations in domestic consumption or tax rates (for instance, Barro

(1979), Bohn (1990), Calvo and Guidotti (1993), Barro (2003), Lustig, Sleet,

and Yeltekin (2008)). Debt that is denominated in a country’s own currency is

thought to help achieve this desired state-contingency because the government

can vary inflation to reduce the real debt burden in bad times.

In this paper, we demonstrate empirically that governments whose local cur-

rency (LC) debt provides them with greater hedging benefits actually borrow

relatively more in foreign currency (FC). This relationship is puzzling from the

∗Wenxin Du and Carolin E. Pflueger are with the University of Chicago and NBER. Jesse

Schreger is with Columbia Business School and NBER. We are grateful to Mark Aguiar; Daniel

Andrei; Adrien Auclert (discussant); John Campbell; Lorenzo Garlappi; Joshua Gottlieb; JuanCar-

los Hatchondo (discussant); Tarek Hassan; Oleg Itskhoki; Thomas Mertens; Vincenzo Quadrini

(discussant); Julio Rotemberg; Rosen Valchev (discussant); Adrien Verdelhan; Jenny Tang; Pierre

Yared; and seminar participants at AEA 2016, UCLA Anderson, Columbia University, Stanford

GSB, MIT Sloan, the 8th Macro-Finance Society Meeting, NBER Summer Institute, UC Santa

Barbara, the San Francisco Federal Reserve, the Federal Reserve Bank of Chicago, the Bank

for International Settlements, and the University of British Columbia for helpful comments. Jiri

Knesl, Sandra Ramirez, George Vojta, and Nanyu Chen provided excellent research assistance.

Pflueger thanks MIT Sloan and Stanford GSB for their hospitality and UBC for research funding

while working on this research. Schreger thanks the Princeton Economics Department for their

hospitality during the research process and the Harvard Business School Division of Research

for financial support. We have read The Journal of Finance disclosure policy and have nothing

to disclose.

Correspondence: Carolin E. Pflueger,Harris School of Public Policy, University of Chicago, 1307

E 60th Street, Chicago, IL 60637; e-mail: cpflueger@uchicago.edu

DOI: 10.1111/jofi.12965

© 2020 the American Finance Association

3097

3098 The Journal of Finance®

perspective of the theory of optimal government debt issuance. We explain it

by adding two features to an otherwise standard debt portfolio choice model—

risk-averse lenders and lack of inflation commitment. If international lenders

are risk-averse and global and domestic output are correlated, lenders will

require a risk premium for holding debt that pays off poorly in domestic down-

turns. In our model, a government that cannot commit to an inflation policy

rule ex ante will use countercyclical inflation ex post to smooth domestic con-

sumption more than is optimal. As a result, lenders charge governments with-

out commitment a risk premium on their LC debt, and these governments

hence face a strong incentive to borrow in FC debt to lower their expected bor-

rowing costs.

We start by investigating empirically whether governments that borrow in

LC debt actually use that debt to smooth domestic consumption. Our sam-

ple, which is determined by the availability of long-term LC bond return data,

comprises 11 developed markets (DMs) and 17 emerging markets (EMs) over

the period 2005 to 2014. We measure the hedging properties of LC debt for

the domestic borrower with the regression beta of LC bond excess returns on

local stock market excess returns.1We refer to this measure as the LC bond-

stock beta. We estimate a significant degree of cross-country heterogeneity in

LC bond-stock betas. If LC bonds tend to fall in value at the same time as

the local stock market, then the LC bond-stock beta will be positive. In that

case, LC debt loses value exactly when a reduction in debt is most valuable

to the borrowing government, thereby insuring the borrower against economic

downturns. Therefore, if governments borrow with LC debt to take advantage

of the domestic smoothing benefits traditionally emphasized in the literature,

we should find a positive relationship between a country’s bond-stock beta and

its LC debt share. By contrast, we find a strong negative relationship between

the LC share of government debt and a country’s bond-stock beta. This pat-

tern holds for the currency composition of total sovereign debt, as well as three

measures of the currency composition of external sovereign debt held by inter-

national investors. It also holds when measuring the hedging properties of LC

bonds relative to those of FC bonds.

We next provide evidence that the cyclicality of LC bond returns is driven by

macroeconomic dynamics and, in particular, the cyclicality of inflation expecta-

tions. If the real burden of LC debt is indeed state-contingent due to inflation

variability,LC bond returns should move inversely with inflation expectations.

This logic suggests that countries with the lowest bond-stock betas should have

the highest betas of inflation expectations with respect to the business cycle.

We confirm this prediction in the data, measuring the cyclicality of inflation

expectations using the beta of long-term inflation forecasts with respect to

long-term output growth forecasts from Consensus Economics. This finding is

1Here, the domestic stock market serves as a proxy for domestic consumers’ stochastic discount

factor (SDF). If there is a benevolent government and a representative consumer, as in our model,

the government’s and consumer’s SDF will coincide.

Sovereign Debt Portfolios 3099

robust to using the beta of realized inflation with respect to realized industrial

production instead of survey expectations for inflation and output.

Two pieces of evidence demonstrate that the LC bonds with the best hedg-

ing value for the borrowing government are also the riskiest for international

lenders. First, the bonds with the highest beta with respect to the local stock

market also have the highest beta with respect to the U.S. stock market. Sec-

ond, international lenders expect to be compensated for bearing this risk, as

captured by higher LC bond risk premia. In addition, we show that cross-

country differences in LC bond risks are correlated with the governments’ in-

flation credibility,based on a text-based measure from newspaper word counts.

These links provide the empirical motivation for our model, where the ability

to commit to an inflation policy function drives both the cyclicality of inflation

and the LC bond risk premium, and therefore the equilibrium choice of the

currency composition of debt.

We present a two-period model to explain the relationship between the choice

of borrowing currency and the hedging properties of LC debt documented in

the data. We consider two types of governments—one that can commit to a fu-

ture inflation policy and one that cannot. The ability to commit is an exogenous

characteristic of the government. Both the currency composition of government

debt and the hedging value of LC debt are endogenous and chosen optimally by

the government. Crucially,debt is priced by risk-averse lenders, whose stochas-

tic discount factor (SDF) is assumed to be correlated with domestic output. A

government with commitment sets its inflation policy as a function of domes-

tic output, before domestic output is realized, and before its debt is priced and

sold to international lenders. Such a government balances its desire to smooth

domestic consumption against the risk premium that lenders will charge it for

inflating more in bad times. By contrast, a government that lacks commitment

and operates under discretion chooses inflation after the debt has been priced

and sold and after observing the state of the domestic economy.

The model has two key results. First, governments without commitment

choose more countercyclical inflation than governments with commitment for

a given LC debt share. This result follows from the fact that governments with-

out commitment do not internalize the effect of their countercyclical inflation

policy on the LC bond risk premium. To show this, we characterize the inflation

policy functions of the two types of governments analytically by log-linearizing

their first-order conditions in a simplified special case. Second, governments

without commitment tilt their borrowing toward FC debt. They do so to reduce

their expected borrowing costs arising from the LC bond risk premium. FC

debt also acts as a commitment device to limit the government’s own incen-

tive to generate countercyclical inflation in the future, thereby lowering the

LC bond risk premium ex ante.2

We next demonstrate that this mechanism can quantitatively explain the

empirical patterns. We calibrate the model twice, once for a government with

2Separately from the implications for inflation cyclicality, a lack of commitment also leads to

higher inflation on average in our model.