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First draft, February 2016. Prepared for the 31st NBER Macro Annual meeting. We benefited from the comments of our discussants John Leahy and Greg Kaplan, and of other conference participants. Part of the research for this paper was sponsored by the ERC advanced grant 324008. Joaquin Saldain and Jean Flemming provided excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. At least one co-author has disclosed a financial relationship of potential relevance for this research. Further information is available online at http://www.nber.org/papers/w22361.ack NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

We characterize the optimal debt-maturity management problem of a government in a small open economy. The government issues a continuum of fi nite-maturity bonds in the presence of liquidity frictions. We fi nd that the solution can be decentralized: the optimal issuance of a bond of a given maturity is proportional to the difference between its market price and its domestic valuation, the latter defi ned as the price computed using the government's discount factor. We show how the steady-state debt distribution decreases with maturity. These results hold when extending the model to incorporate aggregate risk or strategic default.

We study debt policy of emerging economies accounting for credit and liquidity risk. To account for credit risk we study an incomplete markets model with limited commitment and exogenous costs of default following the quantitative literature of sovereign debt. To account for liquidity risk, we introduce search frictions in the market for sovereign bonds. In our model, default and liquidity will be jointly determined. This permits us to structurally decompose spreads into a credit and liquidity component. To evaluate the quantitative performance of the model we perform a calibration exercise using data for Argentina. We find that introducing liquidity risk does not harm the overall performance of the model in matching key moments of the data (mean debt to GDP, mean sovereign spread and volatility of sovereign spread). At the same time, the model endogenously generates bid ask spreads, that can match those for Argentinean bonds in the period of analysis. Regarding the structural decomposition, we find that the liquidity component can explain up to 50 percent of the sovereign spread during bad times; when the sovereign is not close to default, the liquidity component is negligible. Finally, regarding business cycle properties, the model matches key moments in the data. * We would like to thank Robert Townsend, Ivan Werning, George-Marios Angeletos and Alp Simsek for continuous support, guidance, and helpful comments on various stages of this project. We would also like to thank Nicolas Caramp, Arnaud Costinot, Athanasios Orphanides, Dejanir Silva and participants in the MIT International Lunch for helpful comments. We thank the Macro-Financial Modeling Group for financial support. All errors are our own. First Version: November 2014.

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