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Reserve Requirements on Sovereign Debt in the Presence of Moral Hazard -- on Debtors or Creditors?

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  • Joshua Aizenman
  • Stephen J. Turnovsky

Abstract

This paper characterizes the effects of reserve requirements on financial loans in the presence of moral hazard on the lender side (i.e., the anticipation that the taxpayer will bailout lending banks if large default will occur) and sovereign risk on the borrower side. The impacts of such reserve requirements on the equilibrium degree of default risk and borrowing are analyzed, and their welfare implications for both the borrowing and the lending nations discussed. More generous bailouts financed by the high income block encourage borrowing and increase the probability of default. We show that the introduction of a reserve requirement in either country reduces the risk of default and raises the welfare of both the high income block and the emerging market economies. In these circumstances, the lender's optimal reserve requirement is shown to increase with the expected bailout. Such a policy induces the lender to internalize the expected tax payer cost of the bailout. Thus a more generous bailout that is accompanied by an optimal adjustment in the lender's reserve requirements exactly neutralizes its effects on welfare, leaving welfare in both countries unchanged. Unlike the case of the lender, the effect of the more generous bailout on the borrower's optimal reserve requirement is ambiguous. The imposition of the reserve requirement may also improve the availability of information about the debt exposure of the emerging market economies, which by itself will reduce the optimal lender's reserve requirements, and may prevent drying up' the market for sovereign debt.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7004.

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Date of creation: Mar 1999
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Publication status: published as Aizenman, Joshua and Stephen J. Turnovsky. "Reserve Requirements On Sovereign Debt In The Presence Of Moral Hazard - On Debtors Or Creditors?," Economic Journal, 2002, v112(476,Jan), 107-132.
Handle: RePEc:nbr:nberwo:7004

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Cited by:
  1. Theo S Eicher & Uwe Walz & Stephen Turnovsky, 2000. "Financial Liberalization and Capital Flow Reversals:," Working Papers, University of Washington, Department of Economics 0003, University of Washington, Department of Economics.
  2. Stephen Turnovsky & Pradip Chattopadhyay, 1998. "Volatility and Growth in Developing Economies: Some Numerical Results and Empirical Evidence," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 0055, Department of Economics at the University of Washington.
  3. Joshua Aizenman, 2010. "Hoarding international reserves versus a Pigovian tax-cum-subsidy scheme: Reflections on the deleveraging crisis of 2008-9, and a cost benefit analysis," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Oct.
  4. Stephen J. Turnovsky & Santanu Chatterjee, 2004. "Tied Versus Untied Foreign Aid: Consequences for a Growing Economy," Computing in Economics and Finance 2004, Society for Computational Economics 8, Society for Computational Economics.
  5. Theo S. Eicher & Stephen J. Turnovsky & Uwe Walz, 2000. "Optimal Policy for Financial Market Liberalizations: Decentralization and Capital Flow Reversals," German Economic Review, Verein für Socialpolitik, Verein für Socialpolitik, vol. 1(1), pages 19-42, 02.
  6. Aizenman, Joshua, 2005. "Ex ante carrots instead of ex post sticks: two examples," Santa Cruz Department of Economics, Working Paper Series qt22k9w6ck, Department of Economics, UC Santa Cruz.
  7. Eza Ghassan Al-Zein, 2008. "Reserve Requirements, the Maturity Structure of Debt, and Bank Runs," IMF Working Papers, International Monetary Fund 08/108, International Monetary Fund.
  8. Noy, Ilan, 2008. "Sovereign default risk, the IMF and creditor moral hazard," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 18(1), pages 64-78, February.
  9. Aizenman, Joshua & Marion, Nancy, 2002. "Reserve Uncertainty and the Supply of International Credit," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(3), pages 631-49, August.
  10. Rangan Gupta, 2004. "Costly State Monitoring and Reserve Requirements," Working papers, University of Connecticut, Department of Economics 2004-33, University of Connecticut, Department of Economics, revised Jul 2005.

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