Costs and benefits of foreign reserve holdings: Debt-service savings

This paper adds to the existing literature which studies the costs and benefits of the foreign reserve holdings. The paper investigates empirically and theoretically the relationship between foreign reserves of the developing countries and sovereign risk-premiums and how an increase in reserves can result in debt-service savings for the sovereign.;When a country faces an unexpected inflow of foreign cash, it is presented with the two options---reserve accumulation or partial debt repayment. Both options result in the reduction of the risk-premium and may lead to lower debt service on the existing foreign debt. However, the size of the debt-service savings is different for each country and largely depends on its initial financial situation and the sensitivity of the risk-premium to the changes in debt and reserves.;Countries such as Argentina, Brazil, Mexico and Russia, which are characterized by large stocks of foreign debt and lower levels of foreign reserves relative to the rest of the countries in the 'emerging markets' group, appear to benefit more from reserve accumulation rather than from partial debt repayment. This is contrary to the view that such countries should use any extra cash to reduce their already large stocks of foreign debt. However, given the excessive debt, repaying a small portion of it doesn't affect the risk-premium as much as reserve accumulation would. Therefore, reduction in the debt-service is much smaller under partial debt repayment. It may explain, why these countries choose not to repay their debt and channel the cash to building up their foreign reserves.