Debt and International Reserves in Emerging Markets: Output Externalities or Precautionary Savings?

Abstract

We study the joint behavior of external debt, international reserves, and the real interest rate based on a dynamic regime-switching small open economy model that incorporates the salient features of economic crises in emerging markets. Our model allows an assessment of the two well-known motives behind reserve accumulation: output externalities and precautionary savings against sudden stops. Using data from 24 emerging countries from 1970 to 2017, we estimate the model and show that both motives matter in many of our sample countries, with international reserves serving as an instrument to sustain higher levels of output and insure against disruptions from crises. The model is quantitatively successful at matching various aspects of the data that exhibit substantial variation across these countries. We also demonstrate that the contribution from output externalities is heterogeneous in direction and magnitude, which informs the debate concerning the two motives in the literature.

Keywords: Debt; International reserves; Small open economy model; Interest rate premium; Precautionary savings; Output externality; Regime-switching; Emerging market

JEL Classification: E21; E43; F32; F34; H63