Foreign reserves, government debt and endogenous risk premium

Abstract

Policy makers in Sub-Saharan Africa, as elsewhere, often need to find an operational way to assess reserve adequacy. This paper looks at the optimal level of foreign reserves for commodity exporting African countries using a small open endowment economy model. We assume that reserves provide insurance; allowing countries to smooth domestic absorption against the disruption induced by a large adverse price shock associated with a fall in output. Apart from the fall in output, price shocks are accompanied by a failure to roll over outstanding external shortterm debt. For plausible values of model parameters, the model can account for the average level of reserve holdings by Sub-Saharan African countries during recent years. Actual value of optimal reserves is sensitive to the choice to benchmark parameters. We therefore do sensitivity analysis for our benchmark results towards the end.