Optimal Reserve Management and Sovereign Debt

31 Pages Posted: 27 Jun 2007

See all articles by Laura Alfaro

Laura Alfaro

Harvard University

Fabio Kanczuk

University of São Paulo (USP) - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: June 2007


Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the reserve accumulation does not play a quantitative important role in this model. In fact, we find the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.

Keywords: foreign reserves, sovereign debt, default, sudden stops

JEL Classification: F32, F33, F34, F4

Suggested Citation

Alfaro, Laura and Kanczuk, Fabio, Optimal Reserve Management and Sovereign Debt (June 2007). HBS Finance Working Paper No. 07-010, Available at SSRN: https://ssrn.com/abstract=996077 or http://dx.doi.org/10.2139/ssrn.996077

Laura Alfaro (Contact Author)

Harvard University ( email )

Cambridge, MA 02138
United States

Fabio Kanczuk

University of São Paulo (USP) - Department of Economics ( email )

Av. Prof. Luciano Gualberto 908
Sao Paulo SP, 05508-900
011-55-11-818-5915 (Phone)
011-55-11-3661-7333 (Fax)

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