UC Berkeley

This dissertation explores the relationship between sovereign debt ownership, default probabilities, and debt returns, focusing on the increasing domestic debt ownership in devloped countries since the global financial crisis in 2007. It also explains, both theoretically and empircally, how changes in sovereign debt maturity structure would affect the real economy. This dissertation helps advance the study of the linkages between sovereign debt composition, asset prices and the real economy.

In the first chapter, I study the relationship bewteen sovereign debt default and debt ownership structure. Major developed countries have experienced a significant run-up in public debt after the onset of the global financial crisis in 2008. However, the impact on sovereign debt ownership varies across countries. Specifically, the share of debt held by domestic banks has increased in GIIPS countries but declined in non-GIIPS countries. I explain the cross-country differences in debt ownership structure using a dynamic equilibrium model with strategic and non-discriminatory defaults, in which sovereign debt can serve as collateral for expanding private investments. The key insight is that the share of debt held domestically is positively correlated with the government's incentive to default. Consequently, the model predicts that the share of domestically-held debt is strictly increasing in total debt only in highly-indebted countries whose debt has low collateral value. My result is consistent with the notion that domestic debt is a committment device for debt repayment. The key policy implication is that changes in debt ownership are important indicators for the optimality of public debt level. Using data from a panel of 11 countries between 2007 and 2014, I find evidence consistent with these predictions.

In the second chapter, I study the interaction between monetary and fiscal policies, and how changes in fiscal policies, such as the level of debt and debt maturity composition, would affect inflation, the real economy and asset prices. I developed a three-period equilibrium model, in which monetary policies are modelled as open market operations. In my model, inflation and the term structure of interest rates are jointly determined by monetary and fiscal policies, and therefore Sargent (1981)'s "game of chicken'' problem is avoided. I show from the model that fiscal instruments, such as the primary surplus, and the level and maturity structure of government debt, have important implications on inflations and the term structure of interest rates. I then provide robust empirical evidence on how changes in debt-maturity structure are associated with changes in future inflation using U.S. data. One percent increase in the fraction of short-term debt issued is associated with more than 0.2 percent increase in future inflation of different horizons. Empirical evidecne also shows that changes in the short-end of the maturity structure has the most explanatory power over short- and medium- horizons, whereas changes in the long-end of the maturity structure has the most explanatory power over long- horizons.