Nominal Exchange Rate Volatility, Default Risk and Reserve Accumulation

The paper investigates how nominal exchange rate volatility affects a sovereign’s default risk and its incentive to accumulate reserves. The model considers an environment where the sovereign faces a currency mismatch problem and is subject to volatile exchange rate fluctuations. This implies that when the exchange rate depreciates, the debt burden in terms of domestic currency increases, leading to higher default risk and borrowing costs. To insure against this risk, the sovereign optimally accumulates reserves to (i) smooth consumption when borrowing becomes costly, (ii) to hedge against the depreciation of the exchange rate, and (iii) to reduce the volatility of the exchange rate. The model is then calibrated using data from Mexico (1991-2015). The model can replicate the positive association between nominal exchange rate volatility and sovereign default risk. It can also generate more than half of the reserve holdings in Mexico. Moreover, all three channels of reserve accumulation are shown to be quantitatively important.