Seigniorage and Sovereign Default: The Response of Emerging Markets to COVID-19

RePEc Short ID: pko790
ORCID iD: 0000-0001-8464-2470

Espino, Emilio; Kozlowski, Julian; Martin, Fernando M.; Sanchez, Juan M.

doi:10.20955/wp.2020.017

Working Paper Revision

Seigniorage and Sovereign Default: The Response of Emerging Markets to COVID-19

Abstract: Monetary policy affects the tradeoffs faced by governments in sovereign default models. In the absence of lump-sum taxation, governments rely on both distortionary taxes and seigniorage to finance expenditure. Furthermore, monetary policy adds a time-consistency problem in debt choice, which may mitigate or exacerbate the incentives to accumulate debt. A deterioration of the terms-of-trade leads to an increase in sovereign-default risk and inflation, and a reduction in growth, which are consistent with the empirical evidence for emerging economies. An unanticipated shock resembling the COVID-19 pandemic generates a significant currency depreciation, increased inflation, and distress in government finances.

Keywords: Default; Fiscal Policy; Sovereign Debt; Emerging Markets; Inflation; Time-consistency; Crises; COVID-19; Seigniorage; Country Risk; Exchange Rate;