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Reserve management and sovereign debt cost in a world with liquidity crises

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  • Flavia Corneli

    ()
    (Bank of Italy)

  • Emanuele Tarantino

    (University of Bologna)

Abstract

The accumulation of large amount of sovereign reserves has fuelled an intense debate on the associated costs. In a world with liquidity crises and strategic default, we model a contracting game between international lenders and a country, which delivers the country's optimal portfolio choice and the cost of sovereign debt: at equilibrium, the sovereign allocates the borrowed resources to either liquid reserves or an illiquid and risky production project. We study how the opportunity cost of hoarding reserves is affected by the financial and technological characteristics of the economy. In line with recent empirical evidence, we find two important results: the cost of debt decreases in the level of reserves if the probability of liquidity shocks is high enough; however the cost of debt increases in reserves when the lenders anticipate that the country has an incentive to default after a liquidity shock. Indeed, we show that the country may choose to retain reserves instead of employing them to inject the liquidity needed to bring the production project to maturity.

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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 797.

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Date of creation: Mar 2011
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Handle: RePEc:bdi:wptemi:td_797_11

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Keywords: sovereign debt; international reserves; liquidity shock; strategic default;

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References

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  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 1676-1706, August.
  2. Guido Lorenzoni, 2007. "Inefficient Credit Booms," NBER Working Papers 13639, National Bureau of Economic Research, Inc.
  3. Michael Dooley & David Folkerts-Landau & Peter Garber, 2005. "An essay on the revived Bretton Woods system," Proceedings, Federal Reserve Bank of San Francisco, issue Feb.
  4. Adrien Verdelhan & Nicola Borri, 2010. "Sovereign Risk Premia," 2010 Meeting Papers 1122, Society for Economic Dynamics.
  5. Alfaro, Laura & Kanczuk, Fabio, 2009. "Optimal reserve management and sovereign debt," Journal of International Economics, Elsevier, vol. 77(1), pages 23-36, February.
  6. Ricardo Caballero & Stavros Panageas, 2005. "A Quantitative Model of Sudden Stops and External Liquidity Management," NBER Working Papers 11293, National Bureau of Economic Research, Inc.
  7. repec:bla:restud:v:75:y:2008:i:3:p:809-833 is not listed on IDEAS
  8. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  9. Maurice Obstfeld & Jay C. Shambaugh & Alan M. Taylor, 2009. "Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008," NBER Working Papers 14826, National Bureau of Economic Research, Inc.
  10. Alfaro, Laura & Kanczuk, Fabio, 2005. "Sovereign debt as a contingent claim: a quantitative approach," Journal of International Economics, Elsevier, vol. 65(2), pages 297-314, March.
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Cited by:
  1. Daniel Kapp, 2012. "The optimal size of the European Stability Mechanism: A cost-benefit analysis," DNB Working Papers 349, Netherlands Central Bank, Research Department.

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