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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.

Suggested Citation

  • Joshua Aizenman & Nancy P. Marion, 2002. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," NBER Working Papers 9154, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:9154
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    More about this item

    JEL classification:

    • F15 - International Economics - - Trade - - - Economic Integration
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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