Does It Matter How Central Banks Accumulate Reserves? Evidence from Sovereign Spreads

By César Sosa-Padilla and Federico Sturzenegger

There has been substantial research on the benefits of accumulating foreign reserves, but less on the relative merits of how these reserves are accumulated. In this paper we explore whether the form of accumulation affects country risk. We first present a model of endogenous sovereign debt defaults, where we show that reserve accumulation through the issuance of debt contingent on local output reduces spreads in a way that reserve accumulation with foreign borrowing does not. We confirm this model prediction when taking the theory to the data. These results suggest that attention should be placed on the way reserves are accumulated, a distinction that has important practical implications. In particular, our results call into question the benefits of programs of reserves strengthening through external debt such as those typically implemented by multilateral organizations.

Indeed, in this day and age of sophisticated financial instruments, one should be able to do better than issuing debt denominated in US dollars. If shareholders are willing to take reduced dividends in downturns, there should be a market for sovereign debt tied to contingencies. That should work as long as statistical agencies can maintain their independence, which can be a hurdle, though.

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