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Optimal Reserve Management and Sovereign Debt

There is a renewed interest in policy and academic circles about the optimal level of foreign reserves sovereign countries should hold. This recent interest follows the rapid rise in international reserves held by developing countries. In 2005, for example, reserve accumulation amounted to 20% of GDP in lowand middle income countries; whereas this number was close to 5% in high-income countries. This practice has raised interesting questions in the literature regarding the cost and benefits of reserve accumulation.

The cost of holding reserves has been estimated at close to 1% of GDP for all developing countries (Rodrik 2006). Against this cost, an explanation commonly advanced is that countries may have accumulated reserves as an insurance mechanism against the risk of an external crisis—self protection through increased liquidity.

Recently, researchers have undertaken the task of writing analytical models to characterize and quantify the optimal level of reserves and provide policy advice to countries. Most of the formal models used in the current analysis tend to take the level of international debt as given and solve for the optimal liquidity-insurance services that reserves can provide. In other words, the literature has set aside the joint decision of holding sovereign debt and reserves. Although this strategy has allowed for a better understanding of the interplay between foreign reserves and a sovereign’s access to international markets, there are several concerns with this approach. First, some of the implications of this assumption may not be generalized once one considers the joint decision by a sovereign to hold foreign debt and reserves.

For example, in models a la Eaton and Gersovitz (1981), international debt serves an “insurance” role. That is, the demand for international loans derives from a desire to smooth consumption. Hence, given the sovereign’s willingness-to-pay incentive problems, additional reserves in this type of models tend to reduce sustainable debt levels. Second, the strategy of assuming constant debt levels does not address one of the puzzles behind the current accumulation of reserves. Sovereign countries have an alternative way of reducing the probability and negative effects of external crisis: to reduce the level of sovereign debt. That is, even in the case where reserve accumulation has positive liquidity benefits in terms of reducing the probability of suffering financial crises and the output costs associated with it, a similar net asset position can be obtained by reducing instead the level of foreign debt.

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Optimal Reserve Management and Sovereign Debt