money creation and inflation is well-known. In practice, however, seignorage is often a small source of resources both for developing and developed countries. Empirical evidence shows that in normal times, the maximum amount of seignorage revenue collected over an extended period of time is less than 5 percent of GDP (Easterly and Schmidt Hebbel, 1991). During fiscal crisis episodes, the seignorage can become an important (albeit temporary) means of deficit financing (Reinhart and Rogoff, 2009). By running down international reserves, instead of printing money, the government can hope to put off the inflationary effects of a fiscal deficit. This policy is also temporary because it can last just until reserves are depleted, or probably collapse even earlier as pointed out by the theoretical and empirical literature on currency crisis.

Foreign borrowing allows governments to finance the fiscal deficit without creating money supply-driven inflationary pressures or crowding out domestic lending to the private sector. However, external credit flows tend to be volatile, pro-cyclical, and subject to sudden stops (Calvo, 2005). By providing not only financing but also foreign exchange, foreign borrowing may induce a real exchange rate appreciation, thus hampering competitiveness and possibly lowering investment and economic growth (Rodrik, 2008). External debt is typically denominated in foreign currency and this creates additional constraints on monetary policy and exchange rate management. For instance, according to Hausmann (2003), foreign currency-denominated debt lowers the evaluation of solvency because it heightens the dependence of debt service on the evolution of the exchange rate, which is often volatile and subject to shocks and crises. Cespedes, Chang and Velasco (2003) underline that, when there are currency mismatches in the balance sheets of local agents, currency devaluations are contractionary since they induce negative net wealth effects. Under these circumstances, Hausmann and Rigobon (2003) maintain that central banks are reluctant to let the exchange rate float and tend to intervene aggressively in the foreign exchange market and hold more international reserves.

Domestic borrowing, typically denominated in local currency, does not bring about some complications associated with external credit flows. The most prominent concern, instead, is the crowding out effect: issuing domestic debt the governments taps private savings that would otherwise be available to finance private investment. If market-determined interest rates increase, this may reduce investment demand. And if interest rates are controlled or lenders are reluctant to raise them to avoid adverse selection and moral hazard problems, the domestic government borrowing can lead to credit rationing and a reduced supply of funds for private investment.

# **2.2. Domestic financing in LICs**

The theoretical literature on government borrowing and public debt management in LICs is relatively scant – at least compared to advanced economies and emerging markets – and still inconclusive with regard to the benefits and costs of domestic liabilities relative to foreign liabilities. Empirical work, in particular, has been constrained by the lack of a comprehensive domestic public debt database and by the traditional emphasis placed on external borrowing as the main means of fiscal deficit financing in poor countries. The few available studies on LIC government debt reviewed in Table 1 gathered data from multiple sources that were deemed adequate for 3