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Sovereign Risk, Currency Risk, and Corporate Balance Sheets

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  • Jesse Schreger
  • Wenxin Du

Abstract

We examine the question of why a government would default on debt denominated in its own currency. Using a newly constructed dataset of 14 emerging markets, we document that the private sector continues to borrow from abroad in foreign currency while sovereigns increasingly borrow from foreigners in local currency. Because depreciation can be very costly for a corporate sector with a currency mismatch due to foreign currency liabilities, emerging market sovereigns may still prefer to default on local currency sovereign debt rather than inflate the debt away. Using our cross-country dataset, we show that a higher reliance on external foreign currency corporate financing is associated with a higher default risk on sovereign debt. We quantify the effects of corporate balance sheet mismatch on sovereign credit risk by introducing local currency sovereign debt and private currency mismatch into a standard sovereign debt model. The model demonstrates how the currency composition of corporate borrowing affects the sovereign's incentive to inflate or default in times of fiscal stress. Reductions in the share of private external debt in foreign currency can lead to significant reductions in sovereign default risk. A calibration of the model generates the empirical patterns of currency and credit risk in local currency sovereign debt documented in Du and Schreger (2014).

Suggested Citation

  • Jesse Schreger & Wenxin Du, 2014. "Sovereign Risk, Currency Risk, and Corporate Balance Sheets," Working Paper 209056, Harvard University OpenScholar.
  • Handle: RePEc:qsh:wpaper:209056
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    File URL: http://scholar.harvard.edu/schreger/node/209056
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    References listed on IDEAS

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    Cited by:

    1. Javier Bianchi & Juan Carlos Hatchondo & Leonardo Martinez, 2012. "International Reserves and Rollover Risk," NBER Working Papers 18628, National Bureau of Economic Research, Inc.
    2. Diego Perez & Pablo Ottonello, 2016. "The Currency Composition of Sovereign Debt," 2016 Meeting Papers 596, Society for Economic Dynamics.
    3. Patrick Bolton & Haizhou Huang, 2017. "The Capital Structure of Nations," NBER Working Papers 23612, National Bureau of Economic Research, Inc.
    4. Matteo Maggiori & Emmanuel Farhi, 2015. "A Model of the International Monetary System," Working Paper 349586, Harvard University OpenScholar.
    5. Boris Hofmann & Ilhyock Shim & Hyun Song Shin, 2016. "Sovereign yields and the risk-taking channel of currency appreciation," BIS Working Papers 538, Bank for International Settlements.
    6. Enrique Mendoza, 2017. "Optimal Domestic (and External) Sovereign Default," 2017 Meeting Papers 279, Society for Economic Dynamics.
    7. repec:eee:macchp:v2-1697 is not listed on IDEAS
    8. John D. Burger & Francis E. Warnock & Veronica Cacdac Warnock, 2017. "Currency Matters: Analyzing International Bond Portfolios," NBER Working Papers 23175, National Bureau of Economic Research, Inc.
    9. repec:oup:rfinst:v:30:y:2017:i:3:p:703-749. is not listed on IDEAS
    10. Wenxin Du & Carolin E. Pflueger & Jesse Schreger, 2016. "Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy," NBER Working Papers 22592, National Bureau of Economic Research, Inc.
    11. Galo Nuño & Carlos Thomas, 2015. "Monetary policy and sovereign debt vulnerability," Working Papers 1517, Banco de España;Working Papers Homepage.
    12. Valentina Bruno & Hyun Song Shin, 2017. "Global Dollar Credit and Carry Trades: A Firm-Level Analysis," Review of Financial Studies, Society for Financial Studies, vol. 30(3), pages 703-749.
    13. Pablo D'Erasmo & Enrique G. Mendoza, 2016. "Optimal Domestic (and External) Sovereign Default," NBER Working Papers 22509, National Bureau of Economic Research, Inc.
    14. Bolton, Patrick & Huang, Haizhou, 2017. "The Capital Structure of Nations," CEPR Discussion Papers 12157, C.E.P.R. Discussion Papers.
    15. Aguiar, M. & Chatterjee, S. & Cole, H. & Stangebye, Z., 2016. "Quantitative Models of Sovereign Debt Crises," Handbook of Macroeconomics, Elsevier.
    16. Luigi Bocola & Guido Lorenzoni, 2017. "Financial Crises and Lending of Last Resort in Open Economies," NBER Working Papers 23984, National Bureau of Economic Research, Inc.
    17. JungJae Park & Charles Engel, 2017. "Debauchery and Original Sin: The Currency Composition of Sovereign Debt," 2017 Meeting Papers 1558, Society for Economic Dynamics.
    18. Anton Korinek, 2017. "Regulating Capital Flows to Emerging Markets: An Externality View," NBER Working Papers 24152, National Bureau of Economic Research, Inc.

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