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International Reserve Holdings with Sovereign Risk and Costly Tax Collection

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  • Joshua Aizenman
  • Nancy P. Marion

Abstract

This paper analyzes the international reserve-holding behavior of developing countries. It shows that political-economy considerations modify the optimal reserve level determined by efficiency criteria. A country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs and sovereign risk will want to accumulate international reserves as well as external debt. Efficiency considerations imply that reserves are optimal when the benefits they provide for intertemporal consumption and distortion smoothing equal the costs of acquiring them. However, a greater chance of opportunistic behavior by future policy makers reduces the demand for international reserves and increases external borrowing. Political corruption also reduces optimal reserve holdings. We provide some evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-to-reserves ratio is a symptom of opportunistic behavior, a policy recommendation to increase international reserve holdings may be welfare-reducing.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9154.

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Date of creation: Sep 2002
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Publication status: published as Aizenman, Joshua and Nancy Marion. "International Reserve Holdings With Sovereign Risk And Costly Tax Collection," Economic Journal, 2004, v114(497,Jul), 569-591.
Handle: RePEc:nbr:nberwo:9154

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  1. Ben-Bassat, Avraham & Gottlieb, Daniel, 1992. "Optimal international reserves and sovereign risk," Journal of International Economics, Elsevier, Elsevier, vol. 33(3-4), pages 345-362, November.
  2. Frenkel, Jacob A & Jovanovic, Boyan, 1981. "Optimal International Reserves: A Stochastic Framework," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 91(362), pages 507-14, June.
  3. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  4. Alesina, Alberto & Tabellini, Guido, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 57(3), pages 403-14, July.
  5. Elbadawi, Ibrahim A, 1990. "The Sudan Demand for International Reserve: A Case of a Labour-Exporting Country," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 57(225), pages 73-89, February.
  6. Vito Tanzi & Hamid Reza Davoodi, 1997. "Corruption, Public Investment, and Growth," IMF Working Papers, International Monetary Fund 97/139, International Monetary Fund.
  7. Detragiache, Enrica, 1996. "Fiscal Adjustment and Official Reserves in Sovereign Debt Negotiations," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 63(249), pages 81-95, February.
  8. Hipple, F Steb, 1979. "A Note on the Measurement of the Holding Cost of International Reserves," The Review of Economics and Statistics, MIT Press, vol. 61(4), pages 612-14, November.
  9. Van Wijnbergen, Sweder, 1990. "Cash/debt buy-backs and the insurance value of reserves," Journal of International Economics, Elsevier, Elsevier, vol. 29(1-2), pages 123-131, August.
  10. Eaton, Jonathan & Gersovitz, Mark, 1980. "LDC participation in international financial markets : Debt and reserves," Journal of Development Economics, Elsevier, Elsevier, vol. 7(1), pages 3-21, February.
  11. Cukierman, Alex & Edwards, Sebastian & Tabellini, Guido, 1992. "Seigniorage and Political Instability," American Economic Review, American Economic Association, American Economic Association, vol. 82(3), pages 537-55, June.
  12. Lizondo, JoseSaul & Mathieson, Donald J., 1987. "The stability of the demand for international reserves," Journal of International Money and Finance, Elsevier, Elsevier, vol. 6(3), pages 251-282, September.
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