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.