Exchange rate targeting in the presence of foreign debt obligations

We study the impact of foreign debt on the optimal degree of trade-off between the three open economy objectives of the central bank-the desire to smooth exchange rate fluctuations to promote consumption risk sharing, the need for exchange rate flexibility to facilitate expenditure-switching in the face of sticky prices, and the incentive to tilt international prices so as to lower the labor effort of domestic households (terms-of-trade externality)-in a two-country productivity-shock-driven DSGE model with incomplete asset markets and deviations from purchasing power parity. We find that high levels of net foreign debt call for a policy with a significant degree of exchange rate management, which can constrain the extent of otherwise inefficient cross-border wealth transfers that arise due to debt valuation and risk premium effects. In particular, the central bank can improve consumer welfare by up to 0.1% of steady state consumption by responding to exchange rate fluctuations when domestic debt-to-GDP ratio reaches 100%. We also find that the ranking of optimal policy rules depends on the elasticity of import-export substitution. When home and foreign goods are complements, the responsiveness of the real exchange to shocks is muted, in turn mitigating the excessive cross-country wealth transfer associated with the debt valuation effect. In this case, CPI targeting outperforms the nominal peg at high levels of debt by improving international risk sharing.