The Source Matters. How Reserve Financing Affects Sovereign Credit Risk

Abstract

We develop a novel balance-of-payments (BoP) classification to distinguish reserves accumulated via public external borrowing (a precautionary "self-insurance" motive) from those built up through private capital inflows (sterilized "leaning-against-the-wind" of capital flows (or LAW interventions) to estimate the impact of reserve changes on sovereign spreads and financial stress according to their source of finance. We find that increases in reserves funded by private inflows significantly compress sovereign credit spreads and reduce the probability of a financial-stress episode, whereas reserves changes due to external debt issuance have a much weaker or a statistically insignificant effect. These findings hold in pre- and post-global financial crisis subsamples and robustness checks