Working Paper: NBER ID: w28973
Authors: César Sosapadilla; Federico Sturzenegger
Abstract: There has been substantial research on the benefits of accumulating foreign reserves, but less on the relative merits of how these reserves are accumulated. In this paper we explore whether the form of accumulation affects country risk. We first present a model of endogenous sovereign debt defaults, where we show that reserve accumulation through the issuance of debt contingent on local output reduces spreads in a way that reserve accumulation with foreign borrowing does not. We confirm this model prediction when taking the theory to the data. These results suggest that attention should be placed on the way reserves are accumulated, a distinction that has important practical implications. In particular, our results call into question the benefits of programs of reserves strengthening through external debt such as those typically implemented by multilateral organizations.
Keywords: central banks; foreign reserves; sovereign spreads; debt accumulation
JEL Codes: F32; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Accumulating reserves through debt contingent on local output (F34) | Lower sovereign spreads (H63) |
| Accumulating reserves through foreign borrowing (F34) | Higher sovereign spreads (F34) |
| Domestic currency-denominated debt (H63) | Lower sovereign spreads (H63) |
| State-contingent debt provides liquidity and hedging benefits (H74) | Lower sovereign spreads (H63) |
| Higher macroeconomic vulnerabilities (E19) | Increased relevance of state-contingent debt (H74) |
| Method of reserve accumulation (E63) | Financial stability of a country (F65) |