Sovereign debt and reserves with liquidity and productivity crises

• We study the contracting game between a sovereign country and its foreign creditors.
• The country chooses debt and reserves, subject to liquidity and productivity shocks.
• A relationship of complementarity arises at equilibrium between debt and reserves.
• The result hinges on the presence of limited liability and incomplete markets.

During the recent financial crisis, emerging economies have kept accumulating both sovereign reserves and debt. To account for this empirical fact, we model the optimal portfolio choice of a sovereign that is subject to liquidity and productivity shocks. We determine the equilibrium level of debt and its cost by solving a contracting game between sovereign and international lenders. Although raising debt increases the sovereign exposure to liquidity and productivity crises, the simultaneous accumulation of reserves can mitigate the negative effects of such crises. This mechanism rationalizes the complementarity between debt and reserves.