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How International Reserves Reduce the Probability of Debt Crises

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  • Juan Hernandez

    (Inter-American Development Bank)

Abstract

Many emerging economies maintain significant positions in both external sovereign debt and foreign reserves, paying spreads of over 250 basis points on average. Arguments advanced in empirical work and policy discussions suggest that governments may do this because international reserves play a role in reducing the likelihood of sovereign debt crises, improving a country’s access to debt markets. This paper proposes a model that justifies that argument. The government makes optimal choices of debt and reserves in an environment in which self-fulfilling rollover crises a-là Cole-Kehoe and external default a-là Eaton-Gersovitz coexist. This allows for both fundamental and market-sentiment-driven debt crises. Self-fulfilling crises arise because of a lender’s coordination problem when multiple equilibria are feasible. Conditional on the country’s Net Foreign Asset position, additional reserves make the sovereign more willing to service its debt even when no new borrowing is possible, which enlarges the set of states in which repayment is the dominant strategy and, hence, reduces the set of states that admit a self-fulfilling crisis. From an ex-ante perspective, reserves reduce the probability of crises in the future which lowers current sovereign spreads. Quantitatively the model can explain 50% of Mexico’s international reserves holdings, while accounting for key cyclical facts.

Suggested Citation

  • Juan Hernandez, 2018. "How International Reserves Reduce the Probability of Debt Crises," 2018 Meeting Papers 1203, Society for Economic Dynamics.
  • Handle: RePEc:red:sed018:1203
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    References listed on IDEAS

    as
    1. Tavares, Tiago, 2015. "The Role of International Reserves in Sovereign Debt Restructuring under Fiscal Adjustment," MPRA Paper 66962, University Library of Munich, Germany.
    2. Irina A. Telyukova & Randall Wright, 2008. "A Model of Money and Credit, with Application to the Credit Card Debt Puzzle," Review of Economic Studies, Oxford University Press, vol. 75(2), pages 629-647.
    3. Juan Carlos Conesa & Timothy J. Kehoe, 2017. "Gambling for redemption and self-fulfilling debt crises," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(4), pages 707-740, December.
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    Cited by:

    1. Ricardo Sabbadini, 2018. "International Reserves Management in a Model of Partial Sovereign Default," Working Papers, Department of Economics 2018_14, University of São Paulo (FEA-USP).
    2. Luigi Bocola & Guido Lorenzoni, 2017. "Financial Crises and Lending of Last Resort in Open Economies," Staff Report 557, Federal Reserve Bank of Minneapolis.
    3. Ricardo Sabbadini, 2017. "Overcoming the Original Sin: Gains from Local Currency External Debt," Working Papers, Department of Economics 2017_27, University of São Paulo (FEA-USP).
    4. Luigi Bocola & Guido Lorenzoni, 2020. "Financial Crises, Dollarization, and Lending of Last Resort in Open Economies," American Economic Review, American Economic Association, vol. 110(8), pages 2524-2557, August.

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