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Linkages across Sovereign Debt Markets

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  • Cristina Arellano
  • Yan Bai
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Abstract

We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders with concave payoffs. A foreign default increases incentives to default at home because it makes new borrowing more expensive and defaulting less costly. Foreign defaults tighten home bond prices because they lower lenders' payoffs. Foreign defaults make home default less costly by lowering future recoveries, because countries can extract more surplus if they renegotiate simultaneously. In our model, the home country may default only because the foreign country is defaulting. This dependency arises during fundamental foreign defaults, where the foreign country defaults because of high debt and low income, and also during self-fulfilling defaults, where both countries default only because the other is defaulting. The simultaneity in defaults induces a correlation in interest rate spreads across countries. The model can rationalize some of the recent economic events in Europe.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19548.

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Date of creation: Oct 2013
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Handle: RePEc:nbr:nberwo:19548

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  1. Mark Aguiar & Gita Gopinath, 2004. "Defaultable Debt, Interest Rates and the Current Account," NBER Working Papers 10731, National Bureau of Economic Research, Inc.
  2. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
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  13. Cruces, Juan J. & Trebesch, Christoph, 2013. "Sovereign defaults: The price of haircuts," Munich Reprints in Economics 20036, University of Munich, Department of Economics.
  14. Juan J. Cruces & Christoph Trebesch, 2013. "Sovereign Defaults: The Price of Haircuts," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 85-117, July.
  15. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
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