Publications
Publications
- 2016
- HBS Working Paper Series
Sovereign Risk, Currency Risk, and Corporate Balance Sheets
By: Wenxin Du and Jesse Schreger
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.
Keywords
Citation
Du, Wenxin, and Jesse Schreger. "Sovereign Risk, Currency Risk, and Corporate Balance Sheets." Harvard Business School Working Paper, No. 17-024, September 2016.