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Fear of Sovereign Default, Banks, and Expectations-driven Business Cycles

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  • Christopher M. Gunn
  • Alok Johri

Abstract

What is the effect of the fear of future sovereign default on the economy of the defaulting country? The typical sovereign default model does not address this question. In this paper we wish to explore the possibility that changing expectations about future default themselves can lead to financial stress (as measured by credit spreads) and recessionary outcomes. We exploit the "news-shock" framework to consider an environment in which sovereign debt-holders receive imperfect signals about the portion of debt that a sovereign may default on in the future. We then investigate how domestic banks can play a role in transmitting the expectation of default into a realized recession through the interaction of the domestic banks' holdings of government debt and their risk-weighted capital requirements. Our results suggest that, consistent with the data, even in the absence of actual realized government default, an increase in pessimism regarding the prospect of future default results in a rise in yields on government debt and an increase in interest rates on private domestic loans, as well as a recession in the economy.

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Bibliographic Info

Paper provided by McMaster University in its series Department of Economics Working Papers with number 2013-08.

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Length: 32 pages
Date of creation: Jun 2013
Date of revision:
Handle: RePEc:mcm:deptwp:2013-08

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Keywords: expectations-driven business cycles; sovereign defaults; financial inter-mediation; news shocks; business cycles; interest rate spreads; capital adequacy requirements;

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References

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  1. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
  2. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
  3. Ricardo Nunes & Horacio Sapriza & Bora Durdu, 2011. "News and sovereign default risk in small open economies," 2011 Meeting Papers 1355, Society for Economic Dynamics.
  4. Christopher Gunn & Alok Johri, 2011. "News and knowledge capital," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 92-101, January.
  5. Christopher M. Gunn & Alok Johri, 2011. "News, Intermediation Efficiency and Expectations-driven Boom-bust Cycles," Department of Economics Working Papers 2011-02, McMaster University.
  6. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
  7. Luca Guerrieri & Matteo Iacoviello & Raoul Minetti, 2012. "Banks, Sovereign Debt and the International Transmission of Business Cycles," NBER Working Papers 18303, National Bureau of Economic Research, Inc.
  8. Enders, Zeno & Kollmann, Robert & Müller, Gernot, 2010. "Global Banking and International Business Cycles," CEPR Discussion Papers 7972, C.E.P.R. Discussion Papers.
  9. Matteo Iacoviello, 2010. "Financial Business Cycles," 2010 Meeting Papers 1053, Society for Economic Dynamics.
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  13. Robert Kollmann, 2013. "Global Banks, Financial Shocks, and International Business Cycles: Evidence from an Estimated Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(s2), pages 159-195, December.
  14. Sosa-Padilla, Cesar, 2012. "Sovereign Defaults and Banking Crises," MPRA Paper 41074, University Library of Munich, Germany.
  15. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
  16. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
  17. Beaudry, Paul & Dupaigne, Martial & Portier, Franck, 2009. "Modeling News-Driven International Business Cycles," TSE Working Papers 09-117, Toulouse School of Economics (TSE).
  18. Enrique G. Mendoza & Vincenzo Quadrini, 2009. "Financial Globalization, Financial Crises and Contagion," NBER Working Papers 15432, National Bureau of Economic Research, Inc.
  19. Silvio Contessi, 2012. "An application of conventional sovereign debt sustainability analysis to the current debt crises," Review, Federal Reserve Bank of St. Louis, issue May, pages 197-220.
  20. Eric Leeper & Todd Walker, 2011. "Information Flows and News Driven Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 55-71, January.
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Cited by:
  1. Paul Beaudry & Franck Portier, 2013. "News Driven Business Cycles: Insights and Challenges," NBER Working Papers 19411, National Bureau of Economic Research, Inc.
  2. Bergin, Adele & Conefrey, Thomas & FitzGerald, John & Kearney, Ide & Znuderl, Nusa, 2013. "The HERMES-13 macroeconomic model of the Irish economy," Papers WP460, Economic and Social Research Institute (ESRI).

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