Essays on Maturity Structure of Sovereign Debt

Abstract

In the first chapter, I develop a tractable model to study the optimal debt maturity structure and fiscal policy in an environment with incomplete markets, lack of commitment, and opportunity to default by the government. The default on public debt is endogenous and the real interest rate reflects the default risk and the marginal rate of substitution between present and future consumption. I show that the maturity is used to resolve the time-consistency problem: The present government can incentivize future governments to stick to an ex ante optimal sequence of fiscal policies and interest rates. In the second chapter, I show that if both risk-free interest rates and risk premiums can be manipulated, the optimal maturity structure tends to have a decaying profile: The government issues debt at all maturity dates, but the distribution of payments over time is skewed toward the short-term end. Debt maturity data across countries are consistent with model predictions. In the last chapter, I study the sovereign debt maturity structure of a small-open economy in a model with stochastic interest rates and opportunity to default by the government. If default premiums are perfectly foreseen, the optimal debt policy is to issue only one-period debt. Short-term debt disciplines the future governments not to over borrow compared to ex ante optimal allocations because, otherwise, the sovereign has an incentive to dilute the value of long-term debt ex post. If default premiums are stochastic but locally independent of level of debt, sovereign issues consol bonds or maturity is flat. Flat maturity hedges the government against unpredictable swings in interest rates and smooths consumption over states of the world. If default premiums are stochastic (so that maturity can be used as a hedging against changes in interest rates) and continuously increasing in outstanding debt (so that sovereign has an incentive to use short-term debt to minimize dilution of long-term debt in the future), the optimal maturity is mostly short-term debt as minimizing costs associated with lack of commitment is quantitatively more important compared to minimizing costs associated with lack of insurance.