Reserve Accumulation, Sovereign Debt, and Exchange Rate Policy

In the past decade, foreign participation in local-currency bond markets in emerging countries increased dramatically. Additionally, emerging countries are increasingly deviating from inflation targeting regimes, managing their exchange rate and engaging in exchange-rate accumulation. In light of these trends, we revisit sovereign debt sustainability, and the choice of the optimal exchange-rate regime, under the assumptions that countries can accumulate reserves and borrow internationally using their own currency. As opposed to traditional sovereign debt models, asset valuation effects occasioned by currency fluctuations act to absorb global shock and render consumption smoother. Countries do not accumulate reserve to be depleted in “bad” times. Instead, issuing domestic debt while accumulating reserves acts as a hedge against external shocks. We propose that a “pseudo-flexible regime” is the best policy alternative for emerging nations that face international shocks. A quantitative exercise suggests this strategy to be effective for smoothing consumption and reducing the occurrence of default and obtains that optimal reserve holdings turn out to be as large as those presently observed.