Debt Redemption and Reserve Accumulation

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In the past decade, foreign participation in local-currency bond markets in emerging countries increased dramatically. We revisit sovereign debt sustainability under the assumptions that countries can accumulate reserves and borrow internationally using their own currency. As opposed to traditional sovereign-debt models, asset-valuation effects occasioned by currency fluctuations act to absorb global shocks and render consumption smoother. Countries do not accumulate reserves to be depleted in “bad” times. Instead, issuing domestic debt while accumulating reserves acts as a hedge against external shocks. A quantitative exercise of the Brazilian economy suggests this strategy to be effective for smoothing consumption and reducing the occurrence of default.

The past decade has seen the impressive development of domestic government bond markets in emerging market economies (EMEs). Market depth increased, maturities lengthened, and the investor base broadened as a consequence of active foreign participation in local-currency bond markets. At the same time, EMEs accumulated international reserves. However, since the interest earned from international reserves is much lower than that paid on EMEs’ debts, this policy seems puzzling. What is the role of international reserves if these countries have the option of inflating away domestic debt and face no significant external liquidity risks? Why are these reserves not used to repay debt? Are international reserves ultimately increasing or decreasing the sustainability of EMEs’ debt? This paper revisits the question about the optimal level of debt and foreign reserves under novel assumptions that reflect the recent developments of capital flows to emerging markets. In particular, increased foreign participation in local-currency bond markets implies that emerging countries borrow internationally in domestic-currency-denominated bonds. This makes them subject to new sets of constraints regarding repayment of their liabilities, and exposes them to new incentives to actively accumulate international reserves. Two trends characterize capital flows and portfolio holdings of emerging countries over the past decade. The first is a strong increase in foreign participation in local-currency bond markets in emerging economies. Using a newly constructed dataset of the currency composition of sovereign and corporate external debt, Du and Schreger (2015a, b) show that over the past decade major emerging market sovereigns that borrowed as much as 85% of their external debt in foreign currency now borrow more than half in their own currency. Figure 1 displays the increase in domestic-currency denominated debt in a sample of emerging markets

The second trend is the accumulation of international reserves, depicted in Figure 2. Average reserve accumulation in 2014 was more than 25% of GDP in emerging, and only about 5% of GDP in high-income, countries. As documented by the European Central Bank (2006), the size and pace of accumulation of foreign reserves has been unprecedented. Countries have accumulated reserves greater than their IMF quota, exhibiting ratios of reserves to imports above four months’ coverage, reserves to short-term external debt maturity above one year (Greenspan-Guidotti rule) and broad money. The increase in reserve assets has not been exclusive of China or the East Asian countries; its ubiquity among developing countries has raised interesting questions in the literature regarding the costs and benefits of reserve accumulation. The cost of holding reserves has been estimated at close to 1% of GDP for all developing countries (Rodrik, 2006). Against this cost, the commonly advanced explanation is that reserves are accumulated as insurance against the risk of an external crisis, by providing increased liquidity. However, borrowing constraints for emerging countries are quite different from what they used to be. More than fifteen years ago, Eichengreen and 0 10 20 30 40 50 60 70 80 90 30 40 50 60 70 80 90 100 2000 2002 2004 2006 2008 2010 2012 2014 Percentage Percentage Brazil Mexico Colombia Phillipines Thailand China Turkey South Africa Peru (right axis) Chile (right axis) 4 Hausmann (1999) advanced the original-sin hypothesis on the limits of emerging markets’ ability to borrow in their own currency. But the gradual redemption of these economies’ debt sins over the past decade might naturally be expected to significantly affect their incentives pertaining to debt default and repayment.