Inflation, default, and the denomination of sovereign debt

Emerging market countries increasingly issue nominal government debt. At the same time, these countries experience sovereign debt crises with default and high inflation. This paper studies the implications of debt denomination for sovereign default and inflation policies. Using bond-level data on government borrowing, I show that default and inflation rates vary systematically with debt denomination: high nominal debt shares are associated with low inflation and default rates. I then build a monetary model of sovereign debt with lack of commitment, in which differences in debt denomination generate this pattern, and the government inflates more when debt is real. Issuing real instead of nominal debt has two effects in the model. On the one hand, real debt reduces the incentive to create costly inflation because the value of the debt is fixed in real terms. It thus helps mitigate the commitment problem. On the other hand, because the commitment problem is smaller, real debt facilitates more debt accumulation over time, causing the government to resort to the printing press after all to finance the debt burden. In a calibrated version of the model this second effect dominates: As in the data, inflation and default rates are higher on average when debt is real instead of nominal. Default risk helps generate large differences in inflation and default rates across debt regimes as the government optimally inflates in order to avoid default. ∗Latest version available at www.econ.umn.edu/~sund0444. I would like to thank seminar participants at the Minneapolis Fed and members of the Minnesota Trade Workshop, Manuel Amador, Illenin Kondo, Andrea Waddle and David Wiczer for many useful comments, and especially Cristina Arellano, Tim Kehoe and Fabrizio Perri for all the advice and guidance. All errors are mine.