International Reserve Holdings with Sovereign Risk and Costly Tax Collection

Abstract

We derive a precautionary demand for international reserves in the presence of sovereign risk and show that political-economy considerations modify the optimal level of reserve holdings. A greater chance of opportunistic behaviour by future policy makers and political corruption reduce the demand for international reserves and increase external borrowing. We provide evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-toreserves ratio is a symptom of opportunistic behaviour, a policy recommendation to increase international reserve holdings may be welfare-reducing. Over the past fifteen years, developing countries have increased their participation in international financial markets and faced new challenges. In the aftermath of the 1997‐8 Asian financial crises, some observers have called on emerging markets to reduce short-term external debt relative to international reserve holdings in order to lower their vulnerability to crisis. Countries such as Korea, Taiwan and Chile have managed to build up large stockpiles of foreign-currency reserves in recent years. Does it follow that all developing countries would benefit from increasing their cushion of international reserves to signal they are safe borrowers? As the Lucas Critique suggests, this question cannot be answered without understanding the underlying factors that determine a country’s choice of international reserve holdings. We illustrate this point using a model where both efficiency and politicaleconomy considerations play roles in determining a country’s optimal holdings of international reserves. In the absence of political-economy considerations, a country characterised by volatile output, inelastic demand for fiscal outlays, high tax collection costs and sovereign risk will want to accumulate both international reserves and external debt. External debt allows the country to smooth consumption when output is volatile. International reserves, if they are beyond the reach of creditors, allow the country to smooth consumption in the event of a default on the external debt that results in lost access to international capital markets. 1