A Positive Theory of Foreign Currency Debt

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Abstract
The paper makes a case for foreign currency debt as a hedging device in an open economy subject to stochastic shocks to output. A government can reduce uncertainty in net wealth and in consumption by issuing foreign or domestic currency debt, if unexpected domestic and foreign inflation are negatively correlated with domestic output. Foreign currency debt is desirable in comparison to domestic currency debt, if growth rates of output of both countries are closely related and if domestic inflation is relatively uncertain. In addition, foreign currency debt replaces domestic currency debt as hedge, whenever issuing domestic debt is prevented or discouraged by incentive problems. It also shows that time-consistency problems may motivate capital controls or taxes on international borrowing.
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