Working Paper | HBS Working Paper Series | 2015

Debt Redemption and Reserve Accumulation

by Laura Alfaro and Fabio Kanczuk


Foreign participation in local-currency bond markets in emerging countries has increased dramatically over the past decade. In light of this trend, we revisit sovereign debt sustainability and incentives to default when the sovereign is temporarily excluded from capital markets. Differently from previous analyses, we assume that in addition to accumulating international reserves, countries can borrow internationally using their own currency. As opposed to traditional sovereign debt models (all in foreign currency), the asset valuation effects occasioned by currency depreciation (or appreciation) act to absorb global shocks and render consumption smoother. In this setting, countries do not accumulate high levels of reserves to be depleted in "bad" times. Instead, issuing domestic debt while accumulating high levels of reserves acts as a hedge against negative external shocks. A quantitative exercise, in which our model matches features of the Brazilian economic fluctuations and exchange-rate volatility, suggests this strategy to be highly effective for smoothing consumption and reducing the occurrence of default.

Keywords: foreign reserves; local-currency bonds; carry trade; exchange-rate regimes; International Finance; Currency Exchange Rate; Financial Markets; Developing Countries and Economies;


Alfaro, Laura, and Fabio Kanczuk. "Debt Redemption and Reserve Accumulation." Harvard Business School Working Paper, No. 13-074, February 2013. (Revised August 2015. NBER Working Paper Series, No. 19098, June 2013)