Reserve management and sovereign debt cost in a world with liquidity crises
AbstractThe 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 InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 797.
Date of creation: Mar 2011
Date of revision:
sovereign debt; international reserves; liquidity shock; strategic default;
Find related papers by JEL classification:
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General
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