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A Theory of Optimal Reserves Allocation and Sudden Stops in Emerging Economies

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  • Illenin Kondo

    (University of Minnesota and Federal Reserve Bank of Minneapolis)

  • Sewon Hur

    (University of Minnesota and Federal Reserve Bank of Minneapolis)

Abstract

A wave of financial crises and sudden stops crippled emerging economies during the period of 1997-2001. Since that time, there has been a remarkable increase of reserve holdings in emerging economies; and there have been virtually no sudden stops in these economies. We argue that, in the presence of debt rollover risk, idle reserves make countries more solvent in more states of the world. This in turn makes sudden stops less likely. We derive optimal reserves-to-debt ratios in a small open economy model with endogenous sudden stop probabilities and interest rate premia. Based on this theory of reserves allocation, we present a dynamic multi-country model with Bayesian learning and a regime switch in the stochastic liquidity shocks. This model can quantitatively account for the rise in reserve holdings and the sudden stop frequencies in emerging economies.

Suggested Citation

  • Illenin Kondo & Sewon Hur, 2011. "A Theory of Optimal Reserves Allocation and Sudden Stops in Emerging Economies," 2011 Meeting Papers 1105, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:1105
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    1. Durdu, Ceyhun Bora & Mendoza, Enrique G. & Terrones, Marco E., 2009. "Precautionary demand for foreign assets in Sudden Stop economies: An assessment of the New Mercantilism," Journal of Development Economics, Elsevier, vol. 89(2), pages 194-209, July.
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