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Default of Depreciate

Author

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  • Yasin Kürsat Önder
  • Enes Sunel

Abstract

We propose a theory of domestic and foreign currency debt and limited commitment to exchange-rate and debt repayment policies. Exchange-rate depreciation is costly, but reduces the real value of domestic-currency debt and helps smooth consumption without the full punishment of default. However, during a global liquidity shock, government debt balances endogenously tilt towards hard-currency as in the data, although issuing local-currency debt to foreigners is needed the most to transfer the currency risk. This is because foreign lenders become more risk averse to holding nominal sovereign debt during stress episodes. We show that a modest depreciation of currency following adverse shocks precludes a sovereign default by inflating away outstanding local-currency debt burdens in contrast to a counterfactual economy with fully dollarized sovereign debt. The quantitative application of our theory accounts for the business cycle properties and the currency composition of sovereign debt in Mexico.

Suggested Citation

  • Yasin Kürsat Önder & Enes Sunel, 2021. "Default of Depreciate," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 21/1023, Ghent University, Faculty of Economics and Business Administration.
    • Handle: RePEc:rug:rugwps:21/1023
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    References listed on IDEAS

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    More about this item

    Keywords

    Sovereign default; inflationary bias; investor base; original sin;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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