Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises

52 Pages Posted: 16 May 2011

See all articles by Flavia Corneli

Flavia Corneli

Bank of Italy

Emanuele Tarantino

University of Mannheim - Department of Economics; Tilburg Law and Economics Center (TILEC)

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Date Written: March 15, 2011

Abstract

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. 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, 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

Corneli, Flavia and Tarantino, Emanuele, Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises (March 15, 2011). Bank of Italy Temi di Discussione (Working Paper) No. 797. Available at SSRN: https://ssrn.com/abstract=1831228 or http://dx.doi.org/10.2139/ssrn.1831228

Flavia Corneli (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Emanuele Tarantino

University of Mannheim - Department of Economics ( email )

D-68131 Mannheim
Germany

Tilburg Law and Economics Center (TILEC) ( email )

Warandelaan 2
Tilburg, 5000 LE
Netherlands

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