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Optimal reserve management and sovereign debt

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Author Info
Laura Alfaro
Fabio Kanczuk

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Abstract

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2007-29.

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Date of creation: 2007
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Handle: RePEc:fip:fedfwp:2007-29

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Keywords: Debt ; Default (Finance);

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  8. Frankel, Jeffrey & Cavallo, Eduardo, 2004. "Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality," Working Paper Series rwp04-038, Harvard University, John F. Kennedy School of Government. [Downloadable!]
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  9. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism," NBER Working Papers 13123, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Guillermo Calvo & Alejandro Izquierdo & Luis-Fernando Mejía, 2004. "On the empirics of Sudden Stops: the relevance of balance-sheet effects," Proceedings, Federal Reserve Bank of San Francisco, issue Jun. [Downloadable!]
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    • Eaton, Jonathan & Gersovitz, Mark & Stiglitz, Joseph E., 1986. "The pure theory of country risk," European Economic Review, Elsevier, vol. 30(3), pages 481-513, June. [Downloadable!] (restricted)
    • Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc. [Downloadable!]
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  19. Michael P. Dooley, 2000. "Can Output Losses Following International Financial Crises be Avoided?," NBER Working Papers 7531, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  22. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany. [Downloadable!]
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  23. Frenkel, Jacob A & Jovanovic, Boyan, 1981. "Optimal International Reserves: A Stochastic Framework," Economic Journal, Royal Economic Society, vol. 91(362), pages 507-14, June. [Downloadable!] (restricted)
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  25. Jaewoo Lee, 2004. "Insurance Value of International Reserves: An Option Pricing Approach," IMF Working Papers 04/175, International Monetary Fund. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dirk Niepelt, 2008. "Debt Maturity without Commitment," Working Papers 08.05, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
    Other versions:
  2. Eliza, Nor & M., Azali & Law, Siong-Hook & Lee, Chin, 2008. "Demand For International Reserves in ASEAN-5 Economies," MPRA Paper 11735, University Library of Munich, Germany. [Downloadable!]
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