How International Reserves Reduce the Probability of Debt Crises

Juan Hernandez

No 1203, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: Many emerging economies maintain significant positions in both external sovereign debt and foreign reserves, paying spreads of over 250 basis points on average. Arguments advanced in empirical work and policy discussions suggest that governments may do this because international reserves play a role in reducing the likelihood of sovereign debt crises, improving a country’s access to debt markets. This paper proposes a model that justifies that argument. The government makes optimal choices of debt and reserves in an environment in which self-fulfilling rollover crises a-là Cole-Kehoe and external default a-là Eaton-Gersovitz coexist. This allows for both fundamental and market-sentiment-driven debt crises. Self-fulfilling crises arise because of a lender’s coordination problem when multiple equilibria are feasible. Conditional on the country’s Net Foreign Asset position, additional reserves make the sovereign more willing to service its debt even when no new borrowing is possible, which enlarges the set of states in which repayment is the dominant strategy and, hence, reduces the set of states that admit a self-fulfilling crisis. From an ex-ante perspective, reserves reduce the probability of crises in the future which lowers current sovereign spreads. Quantitatively the model can explain 50% of Mexico’s international reserves holdings, while accounting for key cyclical facts.

Date: 2018
New Economics Papers: this item is included in nep-dge and nep-opm
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