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For comments and suggestions, we thank Laura Alfaro, Tom Sargent, and seminar participants at Berkeley, Harvard, Columbia, Stanford SITE Conference on “Sovereign Debt and Capital Flows” Riksbank Conference “Sovereign Debt and Default”, NYU Stern, the 2012 Society of Economic Dynamics (SED) meeting, Bank of Korea, Central Bank of Chile, Central Bank of Uruguay, the “Financial and Macroeconomic Stability: Challenges Ahead” conference in Istanbul, the IMF Institute for Capacity Development, McMaster University, Torcuato Di Tella, Universidad de Montevideo, Universidad Nacional de Tucuman, and the 2012 Annual International Conference of the International Economic Journal. We thank Jonathan Tompkins for excellent research assistance. Remaining mistakes are our own. The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management, the Federal Reserve Bank of Richmond, or the Federal Reserve System. For the latest version of this paper, please visit http://works.bepress.com/leonardo_martinez.
Frankel and Saravelos (2010), Dominguez et al. (2012) and Gourinchas and Obstfeld (2011) found that economies that had more reserves before the global financial crisis had milder contractions in economic activity during the crisis.
IMF (2001) defines reserves as “official public sector foreign assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitudes of such imbalances,… and/or for other purposes.”
Broner et al. (2012) show that in emerging economies changes in reserves represent about half of purchases of foreign assets by domestic agents and contract significantly during crisis episodes. In addition, they show that debt inflows play a primary role in accounting for changes in non-resident purchases of domestic assets over the business cycle and during crises. Dominguez et al. (2012) document the procyclical behavior of reserves around the global financial crisis.
As reported by Neumeyer and Perri (2005) and Uribe and Yue (2006), in emerging economies, government bond yields rise during economic contractions and are reduced during economic expansions (the correlation between GDP and sovereign bond spreads range between 0 and -0.8). Moreover, government bond yields are about 50 percent more volatile in emerging economies than in developed economies.
We can derive similar results with default risk, but this makes the analysis more complex. We study default risk in the model presented in the next section.
In order to highlight the role of rollover risk and long-duration bonds in accounting for reserve accumulation, this section abstracts from the role of reserves as a way to transfer resources to default states highlighted by Alfaro and Kanczuk (2009).
Changes in credit conditions triggered by “global factors” could also be modeled by shocks that affect the risk compensation demanded by international investors (see Borri and Verdelhan, 2009; Arellano and Bai, 2012; Lizarazo, 2011). Alternatively, one could model an increase in the probability of a self-fulfilling rollover crises à la Cole-Kehoe. In both cases the global factor amounts to an increase in the cost of issuing debt and resemble our sudden-stop shock. However, the analysis Chatterjee and Eyigungor (2012) suggests that the role of self-fulfilling crises may be limited once debt duration is assumed to display the levels observed in the data.
Modelling currency or banking crises are beyond the scope of this paper.
Because the return per period is fixed, modelling long-duration reserves would deliver identical results. We do not allow αt to take negative values. Because markets are incomplete, it is possible that the government may want to issue one-period bonds and buy reserves, but computational reasons prevent us from introducing one-period debt as a third endogenous state variable.
Sovereign debt contracts often contain an acceleration clause and a cross-default clause. The first clause allows creditors to call the debt they hold in case the government defaults on a debt payment. The cross-default clause states that a default in any government obligation constitutes a default in the contract containing that clause. These clauses imply that after a default event, future debt obligations become current.
We use the Macaulay definition of duration that, with the coupon structure in this paper, is given by
Net capital inflows are measured as the deficit in the current account minus the accumulation of reserves and related items.
The time series for the spread is taken from Neumeyer and Perri (2005) for the period 1994-2001 and from the EMBI+ index for the period 2002-2011. The data for public debt is taken from Cowan et al. (2006).
Among combinations of reserves and debt levels that command a spread equal to zero, gross asset positions are undetermined: the government only cares about its net position. This is not a problem when solving the model for our benchmark calibration because such combinations of reserves and debt levels are never optimal. However, this becomes a problem when we assume one-period bonds. In order to sidestep this problem, we solve the model with one-period bonds by allowing the government to choose only its net asset position. As indicated by the negligible mean sovereign spread in Table 3, the government chooses net asset positions that command a spread equal to zero in almost all simulation periods.
In a model with defaults, reserves allow the government to transfer resources to the states in which it will choose to default (see Alfaro and Kanczuk, 2009).
For illustration purposes, we assume differentiability and that the constraint on reserves is not binding.
In contrast, several previous empirical studies do not find evidence of reserves significantly reducing the probability of a sudden stop (e.g., Jeanne, 2007). The relationship between reserves and the probability of a sudden stop is difficult to estimate: sudden stops are relatively rare events and the relationship between sudden stops and economic fundamentals may differ across countries. Several studies using a broader definition of crises do find that higher levels of reserves are associated with a lower crisis probability (see Berg et al., 2005; Frankel and Saravelos, 2010; and Gourinchas and Obstfeld, 2011).