“Who Holds Sovereign Debt and WhyIt Matters”
by Fang, Hardy & Lewis
Discussion by Eric M. Leeper
University of Virginia

June 2024
IMF-CARF-TCER-Waseda ConferenceA Macro Perspective▶ Courageous paper▶ uses micro-finance methods to provide input to macro
policy decisions▶ I focus on one question the paper asks:
1. How much do financing costs rise for a hypotheticaldebt increase?

▶ Can a macro framework help to understand theidentification issues?
▶ Three components▶ government budget constraint▶ bond pricing/demand▶ optimizing behavior

Bond Market Behavior▶ The paper’s setup
Supply :Demand :dt (n) = d(xt (n), dt−1 )hmi,t (n) = hi (Pt (n), xt (n))

Equilibrium : Pt (n)d(xt (n), dt−1 ) =I
X

hi (Pt (n), xt (n))

i=1

▶ xt (n): country-specific objects affect S & D▶ xt (n) assumed to be exogenous!
▶ xt (n) includes economic growth, inflation, exports,
credit ratings exogenous▶ If variables that affect welfare are unaffected by bondmarket outcomes. . .
▶ what is at stake in the answer to the question posed?

Addressing the Question
1. How much do financing costs rise for a hypotheticaldebt increase?
▶ I interpret this as asking about new issuances of debt
▶ For policy decisions “financing costs” are about theoriginal sale prices of bonds▶ Prices on secondary markets, of course, are related,
but irrelevant▶ imagine that primary & secondary markets
segmented, with distinct participants▶ then prices in secondary market unrelated tofinancing costs to government▶ Bond supply naturally begins with the government
budget constraintBond Supply▶ Government budget constraint (nominal bonds)
JX
j=1

Qt (t + j)Bt (t + j) + Pt st =JX

Qt (t + j − 1)Bt−1 (t + j − 1)

j=1

▶ Bond supply is choice of {Bt (t + j)} at each date t▶ given the deficit to be financed, government offers
whatever par value is needed to satisfy the budget▶ prices are equilibrium outcomes▶ st , Pt , and Q’s may be functions of the paper’s xt▶ but their endogeneity doesn’t change the nature ofthe supply decision▶ Recent auctions revealed weak demand at long end▶ Treasury responded by changing maturity structure

Bond Supply▶ Leads me to posit Bst inelastic w.r.t Q▶ st shifts supply▶ maturities offered depend on expected Q’s

Bond Demand▶ Consider a Lucas tree model▶ representative agent (ignoring investor types)▶ output exogenous▶ no government spending: eqm ct = yt
▶ st is taxes net of transfers▶ Central bank sets short nominal rate, Rt▶ Maturity of bonds decays geometrically at rateµ ∈ [0, 1]

A Simple Example▶ Representative household—oneinvestor—maximizes
E0∞X

β t log(ct )t=0

subject to(1 + µQt )Bt−1Qt Bt+ st = yt +PtPt▶ Euler equations
ct +ct Pt
1= βEtRt
ct+1 Pt+1
Qt = R−1t Et (1 + µQt+1 )A Simple Example▶ Demand combines FOC with budget constraint▶ Household’s intertemporal budget constraint∞X

Et mt,t+j ct+j =j=0∞XEt mt,t+j (yt+j − st+j ) +j=0(1 + µQt )Bt−1Pt▶ Bond demand:▶ solve for (1 + µQt )Bt−1 /Pt▶ substitute back into flow budget constraint▶ obtain function for Bdt /PtA Simple Example▶ Equilibrium condition is∞X(1 + µQt )Bt−1= Et
mt,t+j st+j
Pt
j=0

▶ Implies bond demand∞
1 X
Bdt= Et
mt,t+j st+j
Pt
Qt j=1▶ decreasing in Qt▶ increasing in Et PV({st+j }∞j=1 )Bond Market Behavior

Supply :Demand :1[−Pt st + (1 + µQt )Bt−1 ]Qt∞
Pt X
Bdt = Et
mt,t+j st+j
Qt j=1Bst =▶ Note that▶ st enters supply, but not demand▶ {mt,t+j , st+j }, j ≥ 1, enter demand, but not supply▶ Seek elasticity of Bdt w.r.t. Qt : here trivially = −1

Bond Market Behavior
Supply :Demand :1[−Pt st + (1 + µQt )Bt−1 ]
Qt
∞
Pt Xd
Bt = Et
mt,t+j st+j
Qt j=1Bst =▶ Cannot say much more without specifying monetary& fiscal behavior▶ Qt depends on path of R’s (MP)▶ only if st ∼ i.i.d. does shift in S not shift D▶ when st predicts future s—which it does—then stshifts S & D (FP)▶ which mix of MP/FP determines Pt ?

Bottom Line
▶ Macro model reveals the nature of the identification
problems▶ they are daunting▶ simultaneity bias can go in either direction▶ monetary-fiscal interactions create thorny
identification problems▶ those interactions lie at the heart of sovereign bondmarkets▶ Hard to see the behavioral aspects from the paper▶ And mine is the “easy” case: auction market onlyMore Elaborate Modeling▶ Considerations to include▶ banks use sovereign debt to meet regulatoryconstraints (financial repression?)▶ zero-risk weight rule on domestic sovereign bonds
seems critical▶ credit default swaps: may matter for the riskiest bonds▶ how does hedge fund “basis trade” affect demand?
▶ ability to profit from derivatives market▶ These details may aid identification

Final Remark▶ Paper: “While governments issue debt and pay
interest over time, investors focus upon holding
period returns per period as measured in thesecondary market.”▶ Small step to: “Bond markets don’t pay attention tosurpluses.”▶ an argument I frequently hear(t)▶ A bond is redeemed and pays Bt−1
Pt

▶ Price level at redemption matters▶ That price level depends on monetary-fiscal mix▶ Ultimately, the real backing for debt determines thereal payoffs & value of the bond