Dollar denominated sovereign debt risk and restructuring in emerging markets

In this work, we focus on scenarios where dollar-denominated sovereign debt remains substantial. This presents a significant challenge to EME sovereign debt sustainability, particularly in the face of U.S. monetary policy tightening. We construct a two-country monetary general equilibrium model and a small open economy with infinite-horizon extension to evaluate the effects of debt restructuring of EMEs. Our findings suggest benefits of equilibrium sovereign default: we demonstrate that the role of the nominal exchange rate and state-contingent monetary policy in absorbing shocks is limited in a dollarized environment because of the trade-off between relieving the external debt burden and maintaining domestic growth; in contrast, sovereign debt restructuring can effectively help EMEs smooth consumption both across states and time, stabilize nominal exchange rates, and reduce the level of dollar-denominated debt. Moreover, we establish that the contemporaneous use of regulatory policy, with a more lenient debt restructuring policy and contractionary domestic monetary policy, is complementary and yields welfare benefits. Finally, our empirical evidence further supports these theoretical findings.