By Enrico Mallucci
This paper examines how domestic holdings of government debt affect sovereign default risk and government debt management. I develop a dynamic stochastic general equilibrium model with both external and domestic debt that endogenously generates output contraction upon default. Domestic holdings of government debt weaken investors’ balance sheets and induce a contraction of credit and output upon default. I calibrate the model to the Argentinean economy and show that the model reproduces key empirical moments. Introducing domestic debt also yields relevant normative implications. While domestic debt is crucial to determining the risk of default, the efficient internal-external composition of debt cannot be achieved without government intervention. Pigouvian subsidies can restore efficiency.
Government debt owed to domestic or foreign creditors is not equal. Clearly, if there is a risk of default, you want that debt held by people that are not otherwise affected by the default. If debt were largely domestic, residents would lose not only an asset in their portfolio, but also an important collateral, which can further precipitate the economy into a crisis. You want thus to encourage external holding of the debt. Note that as domestic debt is typically more defaulted than external debt, this may mean that a higher proportion of external leads to less default, and thus lower interest rates.