Growth, Liquidity Provision, International Reserves, and Sovereign Debt Capacity∗

I establish a theoretical framework to address three distinct, but interrelated puzzles in international economics: (1) the occurrence of twin crises, (2) the existence of large amounts of sovereign debt, and (3) the presence of substantial amounts of international reserves. By considering the interaction between growth and banking in a small open economy that is unable to commit to repaying its external sovereign debt, my dynamic stochastic general equilibrium (DSGE) model uses Global Games techniques to study the endogenous relationship between domestic bank runs, sovereign debt capacity, international reserves, growth, and macroeconomic fundamentals. The main findings are as follows. First, when excluded from international credit markets, liquidity demands rise in a country’s domestic banking sector, which raise the probability of bank runs and costs of liquidation of long term projects. This creates incentives for repayment and sovereign debt capacity. Second, twin (domestic) banking and (external) sovereign debt crises endogenously emerge within the model. Third, international reserves have “war chest” like properties within the model: they help prevent domestic bank runs, during which incentives for a country to strategically default increase, and can therefore create sovereign debt capacity. Finally, my model can quantitatively generate reasonable amounts of sovereign debt and international reserves in equilibrium. ∗I am extremely grateful to my committee Hui Chen, Leonid Kogan, and Adrien Verdelhan for their guidance and support. I would also like to thank Raj Iyer, Lynn Li, Debbie Lucas, Jonathan Parker, Amir Yaron, as well as participants from the MIT Finance lunch, MIT International lunch, and the Spring 2014 Macro-Financial Modeling Conference for helpful comments and discussions. I am also grateful for financial support from the Macro Financial Modeling group. All errors are my own. †MIT Sloan School of Management. Email: yu [email protected]. Download the latest version of this paper at http://yuxu.mit.edu/sites/default/files/images/yuxu_jmp.pdf