By Sewon Hur and Illenin Kondo
Emerging economies, unlike advanced economies, have accumulated large foreign reserve holdings. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in reducing debt rollover crises (“sudden stops”), akin to the role of bank reserves in preventing bank runs. We find that a small, unexpected, and permanent increase in rollover risk accounts for the outburst of sudden stops in the late 1990s, the subsequent increase in foreign reserves holdings, and the salient resilience of emerging economies to sudden stops ever since. Finally, we show that a policy of pooling reserves can substantially reduce the reserves needed by emerging economies.
Interesting paper that shows that rather small events can trigger larger ones. While this is applied to emerging economies, one can wonder whether this can carry over to Europe today. Of course, the handling of foreign reserves is completely different, but precisely the fact that they are bundled across member countries to address imbalances looks like what the authors are calling for. Maybe this is a real-life test of their proposed policy.