During the recent financial crisis developing countries have continued to accumulate both sovereign reserves and debt. To account for this empirical fact, we model the optimal portfolio choice of a country that is subject to liquidity and productivity shocks. We determine the equilibrium level of debt and its cost through a contracting game between a country and international lenders.
Although raising debt increases the sovereign exposure to liquidity and productivity crises, the simultaneous accumulation of reserves can mitigate the negative effects of such crises. This mechanism rationalizes the complementarity between debt and reserves.
Published in 2016 in: Journal of International Money and Finance, v. 65, pp. 166-194