Working Paper: NBER ID: w30418
Authors: Michael B. Devereux; Steve Pak Yeung Wu
Abstract: This paper studies the interaction between foreign exchange reserves and the currency composition of sovereign debt in emerging countries. Focusing on inflation targeting countries, we find that holdings of foreign reserves are associated with higher local currency sovereign debt, an exchange rate which is less sensitive to global shocks, and a lower exchange rate risk premium in local currency sovereign spreads. We rationalize these findings within a financially constrained model of a small open economy. The Sovereign values local currency debt as a hedge against endowment risk, but since the exchange rate tends to depreciate in times of global downturns, risk averse international investors charge an additional currency risk premium on this debt. When a country optimally uses foreign reserves to lean against the wind in response to global shocks, this dampens the response of the exchange rate, providing insurance for the global investor. By reducing the risk premium on local currency debt, foreign exchange reserves therefore facilitate a higher share of local currency debt in the sovereign portfolio. Quantitatively, we find the welfare benefits for the sovereign from optimal foreign reserves management can be very large.
Keywords: foreign reserves; sovereign debt; emerging markets; inflation targeting
JEL Codes: F30; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher foreign reserves (F31) | increased share of local currency sovereign debt (H63) |
| higher foreign reserves (F31) | less sensitive exchange rate to global shocks (F31) |
| higher foreign reserves (F31) | lower exchange rate risk premium in local currency sovereign spreads (F31) |
| optimal management of foreign reserves (F31) | lower local currency sovereign spreads (F34) |
| optimal management of foreign reserves (F31) | enhanced capacity to issue local currency debt at lower costs (H74) |
| optimal management of foreign reserves (F31) | hedging against endowment risk (G52) |
| optimal management of foreign reserves (F31) | leaning against global economic fluctuations (F44) |