Why Do Emerging Economies Accumulate Debt and Reserves?

Abstract

Reserve accumulation has the benefit of decreasing external vulnerability but it comes with a high cost. Emerging economies have been accumulating reserves without reducing their levels of debt. This behavior is puzzling because these economies could also decrease their vulnerability by decreasing their debt. In this paper I construct a stochastic dynamic equilibrium model of a small open economy with non contingent debt and reserve assets. Reserves have the benefit of smoothing consumption when the country is in autarky, after defaulting. Once we assume the asymmetric default costs of Arellano (2008), the results show that the optimal policy is to accumulate positive levels of debt and reserves in equilibrium. These economies accumulate reserves without decreasing debt because it decreases the cost of autarky after they default. For governments to accumulate reserves and debt simultaneously they need to be patient enough to save but still have positive probability of default, the asymmetric default costs generate that.