Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises
39 Pages Posted: 9 Sep 2010 Last revised: 27 Feb 2011
Date Written: January 18, 2011
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. Moreover, 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, in the event of such a shock, 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
JEL Classification: F34, F40
Suggested Citation: Suggested Citation