The Credibility Cost of Redemption: Local Currency Debt and the Inflation Risk Premium

Emerging markets have increasingly borrowed in local currency from foreign investors, a shift that reduces currency mismatch but exposes lenders to inflation risk. Theory predicts that this risk carries a premium that grows with the local currency debt share, yet little is known about how the premium responds to new information. We use central bank speeches—moments when investors must assess the sovereign’s commitment to price stability—to test whether the debt structure conditions the market response. Combining an NLP-based measure of communication tone with data on foreign ownership across 15 emerging economies, we find that tightening signals have no significant association with the term premium when foreign ownership is low. When foreign ownership is high, the same signals are associated with a 3.22 basis point increase in the 10-year term premium at the 75th percentile of the ownership distribution. The premium responds not to expected tightening itself, but to the inflationary pressures the speech reveals: when the local currency debt share is large, investors update on deteriorating fundamentals without fully trusting that the sovereign will act. A model extending Du et al. (2020) rationalizes this pattern: the government’s temptation to inflate scales with the local currency debt share, so adverse signals about fundamentals move the term premium more when there is more debt to debase.