Infation, default and sovereign debt: The role of denomination and ownership

Emerging market governments hold mixed debt portfolios: They borrow at home and abroad in both nominal and real terms. This paper incorporates such a mixed debt structure into a theory of sovereign debt, default and inflation. The government optimally uses both default and inflation to balance its budget. The portfolio structure affects the relative benefits of inflation, default and incentives to accumulate debt. A calibrated version of the model can account for key features of the Mexican economy. We use the model to study if portfolio shifts away from purely real and external debt contributed to emerging market disinflation in the mid 1990s. We find that the answer depends on the distinction between ownership and denomination: Increasingly nominal debt is inflationary if held abroad, but lowers inflation if held at home.