Hoarding International Reserves Versus a Pigovian Tax-Cum-Subsidy Scheme: Reflections on the Deleveraging Crisis of 2008-9, and a Cost Benefit Analysis

We outline the case for supporting self-insurance by imposing a tax on external borrowing in a model of an emerging market. Entrepreneurs finance tangible investments via bank intermediation of foreign borrowing, exposing the economy to negative fire-sale externalities at times of deleveraging; a risk that increases with the ratio of aggregate external borrowing to international reserves. Price taking economic agents ignore their marginal impact on the expected cost of a deleveraging crisis. The optimal borrowing tax reduces the distorted activity, external borrowing, and induces borrowers to co-finance the precautionary hoarding of international reserves.

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This paper was revised on December 5, 2011

Acknowledgments

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