Working Paper: CEPR ID: DP16969
Authors: Refet S. Grkaynak; Sang Seok Lee; Sheung Luk; Ju Hyun Pyun
Abstract: 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.
Keywords: international reserves; external debt; real interest rate; emerging markets; sudden stops; precautionary savings; regime-switching small open economy model; mercantilism; output externalities
JEL Codes: E43; F32; F34; F41; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reserve accumulation (E21) | precautionary savings (D14) |
| reserve accumulation (E21) | GDP growth (O49) |
| sudden stops (F32) | debt management (H63) |
| sudden stops (F32) | reserve management (Q26) |
| Asian Financial Crisis (F65) | reserve accumulation (E21) |