The role of international reserves in sovereign debt restructuring under fiscal adjustment

Tiago Tavares

Journal of Economic Dynamics and Control, 2025, vol. 174, issue C

Abstract: Highly indebted developing economies commonly also hold large external reserves. This behavior seems puzzling given that governments borrow with an interest rate penalty to compensate lenders for default risk. Although reducing external debt to the same extent as international reserves would reduce the interest payment burden, reserves can have additional insurance benefits during default crises. Moreover, reserves can also be used to improve lenders recovery rates upon default, thus decreasing the interest rate penalty in non-defaulting times. A standard model of sovereign default risk, augmented with distortionary tax policies and debt restructuring, can replicate quantitatively the observed data patterns on external debt and reserves holdings.

Keywords: Sovereign default; International reserves; Distortionary taxation; External debt; Sudden stops; Debt renegotiation (search for similar items in EconPapers)
JEL-codes: E62 F32 F34 F41 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:174:y:2025:i:c:s0165188925000466

DOI: 10.1016/j.jedc.2025.105080

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