Local Currency Denominated Sovereign Loans - A Portfolio Approach to Tackle Moral Hazard and Provide Insurance

This paper studies how the currency composition of public debt affects debt sustainability in developing countries. We show empirically that the debt-to-GDP ratio tends to grow at a faster rate when countries with a high share of foreign currency debt face a currency depreciation. The paper also discusses the moral hazard problems associated with the presence of domestic currency debt and shows that, for the average country, there is no evidence of a positive correlation between local currency borrowing and inflation. However, moral hazard is a concern for countries with weak institutions where we find that a large share of domestic currency debt is associated with higher inflation. The paper also develops a stylized model that emphasizes the complementarities between foreign and local currency borrowing and highlights that they are complements rather than substitutes. The key intuition is that, while foreign currency debt reduces the incentives to debt monetization, local currency improves debt sustainability by providing a better hedge against external shocks. The paper concludes that the policy framework should consider encouraging a mix of foreign and domestic currency borrowing. This is likely to be particularly useful for low-income countries that are jointly characterized by weak institutions (hence, the importance of the commitment device associated with foreign currency debt) and large external shocks (hence, the importance of the insurance element associated with the presence of domestic debt).