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Signaling Credibility --- Choosing Optimal Debt and International Reserves

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  • Joshua Aizenman
  • Jorge Fernández-Ruiz

Abstract

This paper evaluates the challenges facing developing countries when there is uncertainty about the policy maker type. We consider a country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs, and sovereign risk, where future output depends on the type of policymaker in place today. There are two policymakers -- type T chooses debt and international reserves to smooth tax collection costs; type S has higher discount factor, aiming at obtaining current resources for narrow interest groups, and preferring not to undertake costly reforms that may enhance future output. Financial markets do not know the type of policymaker in place and try to infer its type by looking at its financial choices. We show that various adverse shocks (lower output, higher real interest rate, etc.) can induce a switch from an equilibrium where each policy maker chooses its preferred policy to another where T distorts its policies in order to separate itself from S in the least costly way. This is accomplished by type T reducing both international reserves and external debt. Further decline in output would induce type T to lower debt, and reserves would fall at a higher rate than otherwise expected.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12407.

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Date of creation: Aug 2006
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Publication status: published as Aizenman, Joshua and J. Fernández-Ruiz. “Signaling Credibility — Choosing Optimal Debt and International Reserves." The Journal of the Korean Economy 10, 1 (2009): 1-28.
Handle: RePEc:nbr:nberwo:12407

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  1. Joshua Aizenman, 2005. "Financial Liberalization in Latin-America in the 1990s: A Reassessment," NBER Working Papers 11145, National Bureau of Economic Research, Inc.
  2. Fernandez-Ruiz, Jorge, 2000. "Debt Buybacks, Debt Reduction, and Debt Rescheduling under Asymmetric Information," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 32(1), pages 13-27, February.
  3. Aizenman, Joshua & Marion, Nancy P., 2003. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," Santa Cruz Center for International Economics, Working Paper Series, Center for International Economics, UC Santa Cruz qt9s7978n1, Center for International Economics, UC Santa Cruz.
  4. Acharya, Sankarshan & Diwan, Ishac, 1993. "Debt Buybacks Signal Sovereign Countries' Creditworthiness: Theory and Tests," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(4), pages 795-817, November.
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