The effect of inflation targeting and financial openness on currency composition of sovereign international debt

• Published in: Journal of international money and finance 2019-10, Vol.97, p.1-18
• Main Authors: Ogrokhina, Olena, Rodriguez, Cesar M.
• Format: Article
• Language: English
• Subjects: Capital account openness; Currency composition; Developing countries; Inflation targeting; International sovereign debt
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2019.05.004

•Inflation targeting combined with capital account openness can reduce the original sin.•Original sin is 11pp lower in financially open targeting countries compared to non-targeting.•Empirical strategy addresses the self-selection bias associated with both policies.•Threshold level of financial openness needed to get the benefits of inflation targeting.•Joint effect significantly increases three years after adopting inflation targeting. This paper analyzes the joint effect of inflation targeting and capital account openness in promoting changes to the currency composition of sovereign international debt in developing countries. First, using difference-in-differences in combination with entropy balancing, we offer empirical evidence that the adoption of inflation targeting together with high capital account openness can significantly reduce the reliance on foreign currency denominated sovereign international debt. We find that financially integrated inflation-targeting countries have 11 percentage points lower foreign currency shares in their sovereign debt compared to non-targeting countries. Second, we determine the threshold level of financial openness that countries need to attain before they see the full benefits of inflation targeting. Third, the joint effect of inflation targeting and capital account openness significantly increases three years after the policy implementation. Our results are robust to alternative specifications which include instrumental variables to account for the endogeneity of the policy.