International reserves have become increasingly important policy tools for developing economies that are, simultaneously, highly indebted. This fact seems puzzling given that governments in these countries borrow with an interest rate penalty to compensate lenders for default risk. Reducing debt to the same extent as reserves would maintain net liabilities constant while decreasing the cost in interest payments. However, holding reserves can have insurance benefits if the economy experiences financial crisis. To rationalize the levels of international reserves and external debt observed in the data, a standard dynamic model of equilibrium default is studied with two fundamental extensions: distortionary taxation and debt restructuring. This paper shows that fiscal adjustments induced by sovereign default can generate large demand for reserves if taxation is distortionary. At the same time, a non-negligible position in reserves modifies the debt restructuring negotiations upon default. A calibrated version of the model produces recovery rate schedules that are increasing with reserves, as seen in the data, being also able to replicate large positions of reserves and debt to GDP. Finally, I study how both mechanisms play a key quantitative role to generate such result, in fact, not including them, produces a counterfactual demand for reserves that is close to zero.
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