Reserve Accumulation, Macroeconomic Stabilization, and Sovereign Risk

Abstract

In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. We propose a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we show that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. Reserves increase debt sustainability to such an extent that financing reserves with debt accumulation may not necessarily lead to increases in spreads. We also study simple and implementable rules for reserve accumulation. Our findings suggest that a simple linear rule linked to spreads can achieve significant welfare gains, while those rules currently used in policy studies of reserve adequacy can be counterproductive.

International Reserves and the Equity Premium

“…As expected, the money supply ratio M2-to-GDP has a positive influence over reserves. We also find that countries with a fixed exchange rate regime tend to accumulate more reserves, which is consistent with previous studies such as Obstfeld et al (2010), Bianchi and Sosa-Padilla (2020) and Samano (2020). In Section B of the Appendix, we display the results for the panel regressions with annual data and with 2 windows of, roughly, 9 years each.…”

“…Again, our contribution is to introduce the equity premium as a targeted moment in the sovereign debt model and analyze its interaction with the optimal level of reserves. Bianchi and Sosa-Padilla (2020) studies the accumulation of reserves in a sovereign default model with nominal rigidities under a fixed exchange rate. They show that the benefit of holding international reserves is to provide macroeconomic stability, since the government can reduce the volatility of unemployment by issuing debt to accumulate reserves.…”

International Reserves and Central Bank Independence

“…15 Even though this fact is outside the scope of this paper, an interesting avenue for future research may be to provide assigns the value "0" to flexible exchange rate regimes and "1" to fixed exchange rate regimes. 16 The coefficient associated with the exchange rate regime implies that countries with fixed exchange rates accumulate more reserves, which is consistent with Bianchi and Sosa-Padilla (2020). Finally, the coefficient associated with sovereign spreads suggests a negative correlation between reserves and spreads, which is inconsistent with the model.…”

“…Related literature.-This paper mainly contributes to the literature on reserve accumulation, in particular the one using sovereign default models to study the joint dynamics of international reserves, public debt, and sovereign spreads. For example, Alfaro and Kanczuk (2009); Bianchi, Hatchondo, and Martinez (2018); Tavares (2018); and Bianchi and Sosa-Padilla (2020). Alfaro and Kanczuk (2009), which is closely related to this paper, enhances a sovereign default model to incorporate the possibility that the government accumulates international reserves.…”

“…In his model, accumulating reserves improves lenders recovery rates after default, which implies a drop in sovereign spreads. Bianchi and Sosa-Padilla (2020) study the accumulation of reserves using a sovereign default model with nominal rigidities under a fixed exchange rate. In their model, issuing debt to accumulate reserves allows the government to reduce the average and the volatility of future unemployment.…”