Optimal Reserve Management and Sovereign Debt
Executive Summary — One of the puzzles in the study of emerging markets is understanding why developing countries accumulate reserves as a means to avoid a financial crisis, rather than work to reduce their sovereign debt. In 2005, for example, reserve accumulation totaled 20 percent of gross domestic product in low- and middle-income countries but only about 5 percent in high-income countries. The costs and benefits of reserve accumulation still aren't clear, nor do economists agree on the optimal level of foreign reserves that sovereign countries should hold. By testing a model of a small, open economy with non-contingent debt and reserve assets, Alfaro and Kanczuk explored the issue in depth. Key concepts include:
- For economists to better understand high levels of foreign reserves holdings, future research should model additional constraints on a sovereign country's ability to reduce its debt.
- Political economy explanations may better address reserve accumulation in emerging markets.
Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.