Working Paper: NBER ID: w18628
Authors: Javier Bianchi; Juan Carlos Hatchondo; Leonardo Martinez
Abstract: We study the optimal accumulation of international reserves in a quantitative model of sovereign default with long-term debt and a risk-free asset. Keeping higher levels of reserves provides a hedge against rollover risk, but this is costly because using reserves to pay down debt allows the government to reduce sovereign spreads. Our model, parameterized to mimic salient features of a typical emerging economy, can account for significant holdings of international reserves, and the larger accumulation of both debt and reserves in periods of low spreads and high income. We also show that income windfalls, improved policy frameworks, and an increase in the importance of rollover risk imply increases in the optimal holdings of reserves that are consistent with the upward trend in reserves in emerging economies. It is essential for our results that debt maturity exceeds one period.
Keywords: International Reserves; Sovereign Default; Rollover Risk
JEL Codes: F41; F42; F44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher reserves (F31) | Lower rollover risk (G32) |
| Higher reserves (F31) | Higher sovereign spreads (F34) |
| Optimal reserve accumulation (D15) | Reduced likelihood of default (G33) |
| Income windfalls (E25) | Increased optimal reserve holdings (E49) |
| Improved policy frameworks (D78) | Increased optimal reserve holdings (E49) |
| Economic conditions (E66) | Government behavior regarding reserves and debt (H63) |