The Capital Structure of Nations∗

We take a corporate finance approach to the question of countries’ funding of investments via foreign-currency denominated debt or domesticcurrency claims. We ask what is the optimal capital structure of a nation? A key conceptual innovation we introduce is an analogy between a nation’s money-claims and corporate equity. What a nation’s money and a firm’s equity have in common is that they both are claims on residual output. Pursuing this analogy, we show that a nation’s optimal funding structure can be characterized as the solution to a tradeoff between inflation costs and expected default costs. Our corporate finance perspective provides a unified framework connecting corporate finance, monetary economics, and international finance. It yields new insights into such issues as the costs and benefits of foreign exchange reserves and the optimal currency composition of sovereign debt. ∗We are grateful to Ailsa Roell, Tano Santos, Jose Scheinkman and Neng Wang for helpful comments, and to Jieyun Wu and Wei Xiong for excellent research assistance. The views expressed in the paper are those of the authors and do not necessarily represent the views of CICC.