Financial frictions, FX reserves, and exchange rate management with local-currency debt

Abstract

Emerging economy central banks often hold large FX reserves while residents carry substantial local-currency-linked external liabilities. With financial frictions creating interest parity gaps, such opposing positions imply a carry cost. In a small open economy with intermediation frictions and inherited local-currency debt, we study optimal reserve and exchange rate policies, explaining why debtor economies may retain reserves rather than netting out costly gross positions. While policy can eliminate costly intermediation by deploying reserves and appreciating the real exchange rate, doing so creates a general equilibrium revaluation effect which raises the real burden of local-currency obligations. Optimal policy retains reserves, accepting some intermediation to avoid a larger revaluation loss. This policy is time-inconsistent: a discretionary central bank prefers stronger ex-post appreciation; a time-consistent equilibrium features more reserve retention and larger interest parity gaps. Revaluation costs restrain reserve deployment; when large, optimal policy retains more reserves during disruptions than in normal times.