The Role of Foreign Currency Debt in Public Debt Management


WP/95/21-EA
The Role of Foreign Currency Debt in Public Debt Management
by Patrick de Fontenay, Gian Maria Milesi-Ferretti, and Huw Pill

This paper focuses on the choice between domestic currency and foreign
currency debt. This aspect of public debt management is of interest
because, among highly indebted countries, significant differences exist in
the currency composition of outstanding public debt. While in Italy the
share of foreign currency debt in total debt has been negligible until
recently, in Ireland it is over one-third. Borrowing in foreign currency
removes the incentive to reduce ex post the real value of government debt
through unexpected inflation. However, it exposes the domestic currency
value of government liabilities to fluctuations in exchange rates.

The paper examines the theoretical determinants of the choice between
domestic and foreign currency debt and presents an empirical analysis of the
behavior of the share of public debt denominated in foreign currency in a
group of member countries of the Organization for Economic Cooperation and
Development, including Belgium, Denmark, Ireland, Italy, New Zealand, and
Sweden. The theoretical analysis focuses on time consistency issues, the
possibility of confidence crisis, the role of incomplete information, and
the hedging role of public debt management. Practical considerations relate
to, inter alia, portfolio management and the balance of payments situation.
The empirical analysis examines the covariance between real interest
payments on domestic and foreign currency debt on the one hand, and
productivity and public spending shocks on the other hand. It also reports
correlations of the share of foreign currency debt in total debt with the
interest differential on domestic versus foreign debt instruments.