Output Concerns and Precautionary Savings in Emerging Markets' Debt and Reserve Accumulation

We study the joint behavior of external debt, international reserves, and the real interest rate based on a dynamic regime-switching small open economy model that incorporates the salient features of economic crises in emerging markets. Unlike reduced form analyses where contributions from different channels are difficult to delineate, our model allows separately assessing both possible motives behind reserve accumulation: mercantilistic behavior (output externalities) and precautionary savings. Using data from 24 emerging countries for 50 years, we estimate the model and show that both motives matter, but to differing degrees, in many of our sample countries, with international reserves serving as an instrument to sustain higher levels of output and insure against disruptions from crises. The model is quantitatively successful at matching various aspects of the data that exhibit substantial variation across these countries. Importantly, when present sudden stop risk and output externalities both have differing impact on debt and reserve management of different countries because of offsetting income and substitution effects.