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Reserve management and sovereign debt cost in a world with liquidity crises

Flavia Corneli () and Emanuele Tarantino

No 797, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: The accumulation of large amount of sovereign reserves has fuelled an intense debate on the associated costs. In a world with liquidity crises and strategic default, we model a contracting game between international lenders and a country, which delivers the country's optimal portfolio choice and the cost of sovereign debt: at equilibrium, the sovereign allocates the borrowed resources to either liquid reserves or an illiquid and risky production project. We study how the opportunity cost of hoarding reserves is affected by the financial and technological characteristics of the economy. In line with recent empirical evidence, we find two important results: the cost of debt decreases in the level of reserves if the probability of liquidity shocks is high enough; however the cost of debt increases in reserves when the lenders anticipate that the country has an incentive to default after a liquidity shock. Indeed, we show that the country may choose to retain reserves instead of employing them to inject the liquidity needed to bring the production project to maturity.

Keywords: sovereign debt; international reserves; liquidity shock; strategic default (search for similar items in EconPapers)
JEL-codes: F34 F40 (search for similar items in EconPapers)
Date: 2011-03
New Economics Papers: this item is included in nep-ppm
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