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Optimal reserve management and sovereign debt

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  • Laura Alfaro
  • Fabio Kanczuk

Abstract

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.

Suggested Citation

  • Laura Alfaro & Fabio Kanczuk, 2007. "Optimal reserve management and sovereign debt," Working Paper Series 2007-29, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2007-29
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    More about this item

    Keywords

    Debt; Default (Finance);

    JEL classification:

    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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