We study the role of government debt maturity in currency unions to identify whether debt management can help governments hedge their budgets against spending shocks. We first use a detailed dataset of debt portfolios of five Euro Area countries to run a battery of VARs, estimating the responses of holding period returns to fiscal shocks. We find that government portfolios,which in our sample comprise mainly of nominal assets, have not been effective in absorbing idiosyncratic fiscal risks, whereas they have been very effective in absorbing aggregate risks. We then setup a formal model of optimal debt management with two countries, a benevolent planner, distortionary taxes and agggregate and idiosyncratic shocks. The theoretical model validates our empirical findings: nominal bonds are not optimal to insure against idiosyncratic shocks. Our key finding is that governments should introduce in their portfolios also inflation indexed long term debt since this allows them to take full advantage of fiscal hedging. Looking at the data, we find a sharp rise in issuances of inflation index bonds in France and in Italy since the beginning of the Euro. We show that bonds linked to French inflation were able to absorb both aggregate and idiosyncratic fiscal risks.
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