Government Debt Denomination Policies before and after the EMU Advent

Through a cost-minimizing approach, this paper derives four joint indicators to assess the ef…ciency of the mix of sovereign debt currencies between the countries belonging to the European Monetary Union (EMU). This theoretical insight enables us to explain why and how the introduction of the euro and the adoption of a common monetary policy may have led to signi…cant changes in debt structure among EMU members, notably in favor of further euro-denominated debt. The interplay of intrinsic and strategic variables yields stylized facts that are consistent with country-speci…c empirical evidence. Following the sovereign debt crisis, we further emphasize the value-added of a coordinated debt issuance policy among EMU countries. I. Introduction The 2010-11 European sovereign debt crisis, triggered by concerns over the credit risk of the Greek government debt, has shown that euro-denominated bond spreads are largely driven by direct default risk. The common currency acts as a cushion against the temptation to perform competitive devaluations to avoid mere default by distressed governments. This case emphasizes that the adoption of a common monetary policy has substantially altered the market perception of the key drivers of sovereign debt value. This major breakthrough nevertheless has raised many questions about the evolution of yield spreads for …xed income securities issued by the Eurosystem member countries. Investors and other market participants scrutinize for (un)sustainable debt levels and country’s debt vulnerability in valuing sovereign debt. Fiscal de…cits and projections for the debt-to-GDP ratio are standard indicators for investors to assess the riskiness of a country’s sovereign debt. However, these indicators alone do not re‡ect the whole situation of a country’s debt. It is also relevant for investors to review the (in)appropriateness of the country’s currency debt structure (proportion of domestic currency denominated debt vs. foreign currency denominated debt) and its maturity pro…le. From that perspective, no indicator can be looked at in isolation. Moreover, if the euro triggered a noticeable change in the relative cost of domestic and foreign debt of European Monetary Union (EMU) member states, one should also observe a corresponding shift in the debt management indicators. These questions are addressed in this paper. We adopt a cost-minimizing approach to the problem of de…ning the appropriate mix of debt currencies with their associated maturities by sovereign governments, which should be their formal goal to reassure investors about their debt management process. Our approach entails the existence of a complete market, which implies that the government’s political commitment is …rmly set and known by market participants at the very moment of the review of debt composition. Consequently, we take as given the level and expected evolution of taxes and government expenditures, which have been …rmly set and communicated to the market. Nevertheless, the impact of these sovereign decisions on the current and future costs of debt is accounted for. Under the framework developed by Du¢ e and Singleton (1999), the yearly cost of sovereign debt is represented by its continuous yield spread. The objective function to minimize should thus be the sum of the total cost incurred over the lifetime of debt denominated in domestic and in foreign currency. Such an approach allows us to stick to the …nancial modeling of yield spreads and to focus on the identi…cation of their determinants. To be convincing, the decision of issuing domestic or foreign debt with their respective