SOVEREIGN RISK AND COSTLY TAX COLLECTION
We derive a precautionary demand for international reserves in the presence of sovereign risk and show that political economy considerations modify the optimal level of reserve holdings. A greater chance of opportunistic behaviour by future policy makers and political corruption reduce the demand for international reserves and increase external borrowing. We provide evidence to support these findings. Consequently, the debt to reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt toreserves ratio is a symptom of opportunistic behaviour, a policy recommendation to increase international reserve holdings may be welfare reducing. Over the past fifteen years, developing countries have increased their participation in international financial markets and faced new challenges. In the aftermath of the 1997 8 Asian financial crises, some observers have called on emerging markets to reduce short term external debt relative to international reserve holdings in order to lower their vulnerability to crisis. Countries such as Korea, Taiwan and Chile have managed to build up large stockpiles of foreign currency reserves in recent years. Does it follow that all developing countries would benefit from increasing their cushion of international reserves to signal they are safe borrowers? As the Lucas Critique suggests, this question cannot be answered without understanding the underlying factors that determine a country's choice of international reserve holdings. We illustrate this point using a model where both efficiency and politicaleconomy considerations play roles in determining a country's optimal holdings of