We document 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 counter-cyclical 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 borrowing in its own currency.

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BFI Working Paper Jun 29, 2020

U.S. Banks and Global Liquidity

Ricardo Correa, Wenxin Du, Gordon Liao
Topics:  Monetary Policy, Financial Markets