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Government Bonds in Domestic and Foreign Currency: The Role of Institutional and Macroeconomic Factors

During the last two decades, capital markets around the world have experienced rapid growth and have become increasingly more integrated. These trends are reflected in the growth of domestic public bond markets and the government participation in international capital markets. At the same time, there have been many financial crises, especially in emerging markets, a phenomenon that has been partly attributed to the increase in debt burdens, particularly in foreign currency. These factors have led to a growing interest regarding the determinants of government bond market development and the currency composition of government bonds.

The literature that studies government debt markets is large, but the particular attention on government bonds emerged in the last decade, as governments replaced bank borrowing with bond issuance. Studies on the general determinants of governments’ desire and ability to issue debt have highlighted macroeconomic stability and political economy factors. The literature following the debt crisis of the early 1980s has concentrated on a country’s ability to issue external debt, then mostly in the form of commercial bank loans.

Following the Brady plan, which resolved the 1980s debt crisis by converting government debt into bonds, and as new debt took increasingly the form of international bonds, research evolved into the explanation of spreads and pricing of government bonds. With the financial crises in the 1990s, government bonds gained even more interest as the size and structure (currency and maturity) of government debt has been identified to lead to vulnerabilities, mismatches, and possibly trigger financial crises.

The currency composition of government bonds has especially received much attention lately, with a number of dimensions being considered. For some countries, particularly emerging economies, borrowing in foreign currency can be less expensive than in domestic currency (or at least appear to be so). But foreign currency debt exposes governments and firms to exchange rate risk, as their revenues typically relate to local currency values. This mismatch increases the likelihood of financial crises and may make self-fulfilling runs possible (see, for example, Krugman, 1999; Jeanne, 2000; Aghion, Bacchetta, and Banerjee, 2001; and Schneider and Tornell, 2004).

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Government Bonds in Domestic and Foreign Currency: The Role of Institutional and Macroeconomic Factors