Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. Some of the implications of this analysis, however, may not be generalized once one considers the joint decision to hold debt and reserves by a sovereign. Given the sovereigns willingness to pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming debt levels constant does not allow addressing one of the puzzles behind the current accumulation of reserves. Sovereign countries have an alternative way of reducing the negative effects of external crisis: to reduce the level of sovereign debt. To study the joint decision of holding sovereign debt and reserves, we construct a small open economy stochastic dynamic equilibrium model, which is then calibrated to a sample of emerging markets. We study different scenarios associated with interest rate shocks, sudden stops, output costs and the use of contingent reserves. A robust quantitative result that emerges is that the optimal policy is not to accumulate reserves. In fact, in most of simulated economies, the optimal level of reserves holding is zero.
Optimal Reserve Management and Sovereign Debt