This paper proposes a stylized two-period two-country OLG model illustrating the potential role played by the nationality of investors on the incentives for a government to renege on its domestic debt. The two countries belong to a Monetary Union where monetary policy is decided by the Union’s Central Bank, while fiscal policy is set by each national government. In the first period, governments issue debt which is acquired both by resident and non resident families. In the second period, public debt must be paid back. Since debt is issued internally, discriminatory taxation against foreign investors is not available. The government can thus choose to repay the debt by levying a tax on resident families’ labour income, or to repudiate it. The repayment scheme is the outcome of the interaction between the government and interest groups (identified by resident and non resident families) with conflicting preferences about debt redemption. Families exert their influence on government decisions by proposing a contribution function contingent on policy outcomes. The main result produced by our model is that if a sufficient share of debt is owned abroad, then incentives to default on domestic debt increase irrespective of the stock of public debt. The main implication of this result is that for a given level of domestic debt, diversification, increasing the share of domestic debt held by foreigners, raises countries’ default risk. This is of some relevance for the EMU where a progressive greater integration of the market for sovereign issuances has been observed.
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