Currency Composition

This paper explores the relationship between the currency composition and bondholder composition of sovereign debt, focusing on the government’s incentives to issue debt denominated in local currency (LC) or foreign currency (FC). We introduce a framework that analyzes the trade-offs that governments face when domestic and foreign demand for bonds react differently to policy changes. The main result is that the government considers the effect on bondholder composition when choosing the currency of its debt. Domestic investors’ demand for LC bonds is higher due to the insurance provided against distortionary taxes.