International Reserve Holdings with Sovereign Risk and Costly Tax Collection

Abstract

This paper analyzes the international reserve-holding behavior of developing countries. It shows that efficiency and political-economy considerations pull in opposite directions in determining a country's optimal reserve holdings. A country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs and sovereign risk will want to accumulate international reserves as well as external debt. Efficiency considerations imply that reserves are optimal when the benefits they provide for intertemporal consumption and distortion smoothing equal the costs of acquiring them. Political-economy considerations reduce the desired reserve level. A greater chance of opportunistic behavior by future policy makers reduces the demand for international reserves and increases external borrowing. We provide some evidence to support these findings. Consequently, the debt/international reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt/reserve ratio is a symptom of opportunistic behavior, a policy recommendation to increase international reserve holdings may be welfare-reducing.