Balance of Payments Sustainability and Optimal International Reserves

In this paper we explore the consequences of bailout packages for the long run reserves policy in emerging market economies. We develop a model that looks at the intertemporal optimization problem of a small open economy that accumulates international reserves at a cost to insure itself against the risk of a balance of payments crisis associated with a fall in output. We consider this problem with and without the possibility of bailouts. The analysis is applied to the Mexican case. Without the possibility of bailout, the model predicts an optimal reserves policy considerably higher than the current long-run reserves policy. When the model accounts for the bailout package that Mexico received after its 1994 Tequila crisis and the possibility of similar rescue packages in the future, the current reserves policy is in the range of the model's predictions. An additional feature of this model is that it explicitly links the optimal level of reserves not only to local policy rules, such as the trade policy and the net liability position, but also to the notion of sustainable BOP, which is, in turn, linked to global factors such as U.S. interest rates and oil prices