A theory of rollover risk, sudden stops, and foreign reserves

Emerging economies have accumulated very large foreign reserve holdings since the turn of the century. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in endogenously reducing debt rollover crises (“sudden stops”) by allowing governments to be solvent in more states of the world. Using a dynamic multi-country environment with learning, we find that a relatively small unanticipated increase in rollover risk jointly accounts for (i) the outburst of sudden stops in the late 1990s, (ii) the increase in foreign reserves holdings, and (iii) the subsequent reduction of sudden stops in emerging economies. We also show that a policy of pooling reserves may substantially reduce reserves because mutual insurance across countries dampens rollover risk.