The Role of International Reserves in Sovereign Debt Restructuring under Fiscal Adjustment

MPRA Paper from University Library of Munich, Germany

Abstract: Highly indebted developing economies commonly also hold large external reserves. This behavior seems puzzling given that governments in these countries borrow with an interest rate penalty to compensate lenders for default risk. Reducing debt to the same extent as reserves would maintain net liabilities constant while decreasing interest payments. However, holding reserves can have insurance benefits in a financial crisis. To rationalize the levels of international reserves and external debt observed in the data, a standard dynamic model of equilibrium default is extended to include distortionary taxation and debt restructuring. This paper shows that fiscal adjustments induced by sovereign default can generate large demand for reserves if taxation is distortionary. At the same time, a non-negligible position in reserves modifies the debt restructuring negotiations upon default. A calibrated version of the model produces recovery rate schedules that are increasing with reserves, as seen in the data, being also able to replicate large positions of reserves and debt to GDP. Finally, I study how both mechanisms play a key quantitative role to generate such result, in fact, not including them, produces a counterfactual demand for reserves that is close to zero.

Keywords: Sovereign default; international reserves; distortionary taxation; external debt; sudden stops; debt renegotiation (search for similar items in EconPapers)
JEL-codes: E62 F32 F34 F41 (search for similar items in EconPapers)
Date: 2015-04-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: The Role of International Reserves in Sovereign Debt Restructuring under Fiscal Adjustment (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:87423

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