Sovereign defaults and optimal reserves management

A long-standing puzzle of international capital flows is why countries hold large amount of external debt and foreign reserves at the same time. To address this puzzle, we propose a sovereign default model where the government decides jointly over the accumulation of long-duration bonds and foreign reserves. When calibrated to the data, the model can successfully explain the simultaneous holdings of debt and foreign reserves. We also show that the relationship between reserves and default risk may be non-monotonic.