81. The role of international reserves in sovereign debt restructuring under fiscal adjustment

Tavares, T. (2025). The role of international reserves in sovereign debt restructuring under fiscal adjustment. Journal of Economic Dynamics and Control, 174. https://doi.org/10.1016/j.jedc.2025.105080This article examines why highly indebted developing economies simultaneously hold large stocks of international reserves, despite the financial cost of doing so. The puzzle arises because reserves earn a low return while external debt carries a higher interest rate, making the coexistence of both positions seemingly inefficient. Nonetheless, many emerging economies maintain reserves exceeding 20% of GDP while holding external debt above 50% of GDP. The study argues that the benefits of reserves outweigh their costs through two main channels: insurance against sudden stops—allowing governments to smooth consumption and avoid default—and improved bargaining power in debt renegotiation, which raises recovery rates and reduces sovereign spreads. Empirical evidence shows that a 10-point increase in reserves relative to GDP reduces spreads by 48 basis points and decreases expected haircuts by 12–15 points. A sovereign default model calibrated to Mexico reproduces realistic reserve and debt levels, highlighting the roles of fiscal distortions and renegotiation. Overall, reserves function as a costly but valuable safety buffer that enhances creditworthiness.