Debt Accumulation, Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises∗ PRELIMINARY VERSION

The accumulation of large amount of sovereign reserves has fuelled an intense debate on the associated costs. In a world with liquidity crises and strategic default, we model a contracting game between international lenders and a country, which delivers the country’s optimal portfolio choice and the cost of sovereign debt: at equilibrium, the sovereign chooses the amount of debt and decides on the allocation of its resources between liquid and safe reserves, and an illiquid and risky production project. In line with recent empirical evidence, we find that the country holds positive amounts of sovereign debt and reserves. Indeed, we show that debt and reserves can be strategic complements: the accumulation of a larger amount of reserves can insure the country against the increase in the likelihood of a liquidity crisis induced by a larger amount of debt. Finally, we show that there might be cases in which the accumulation of sovereign reserves works independently from a precautionary motive. JEL classification: F34, F40.