This paper develops a two-sector small open economy model to analyze the effects of the currency denomination of debt on default risk and interest rates in emerging market economies. Default risk is determined endogenously and depends on the incentives for repayment. The economy can borrow using tradable-denominated nonindexed bonds or bonds whose return is indexed to the domestic price index, which are used as proxies for foreign currency and domestic currency debt, respectively. The model predicts that foreign currency debt leads to lower default risk for high output levels and domestic currency debt reduces the default risk for low output levels. Although the effect of debt denomination on default risk changes with the output level, the default rate of the economy and average interest rates decline as domestic currency borrowing increases. In addition, domestic currency borrowing is found to reduce the countercyclicality of interest rates and the trade balance.
