Leading indicators of sovereign defaults in middle- and low-income countries: the role of foreign exchange reserve ratios in times of pandemic

The context of the global pandemic has brought back to the foreground a renewed challenge of designing effective early warning systems for sovereign debt crises. This paper aims to empirically assess the predictive power of several foreign exchange reserve ratios in 66 middle- and low-income countries during 1973-2017. The main estimation results demonstrate that the reserves to total external debt and the reserves-to-GDP ratios stand out compared with the other predictors and yield good predictive power according to an array of performance criteria. The previous outcome is robust, even at more distant forecast horizons. I eventually show that the reserves to total external debt ratio also displays a fine predictive power from an out-of-sample perspective (i.e., in predicting defaults that occurred in the wake of the COVID-19 crisis). The previous outcome highlights that foreign exchange reserve buffer accumulation is an efficient macroprudential policy instrument that may enable to loosen constraints related to the Mundell trilemma, therefore preventing debt crises by reducing output volatility.