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Contagion of Financial Crises in Sovereign Debt Markets

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  • Lizarazo, Sandra

Abstract

This paper develops a quantitative model of contagion of financial crisis and sovereign default for small open economies that cannot credibly commit to honor their international debts and have common international risk averse investors. The existence of common investors with preferences that exhibit decreasing absolute risk aversion (DARA) generates financial links between the emerging economies sovereign debt markets that help to explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices as function not only of the economy's fundamentals, the investors' characteristics (wealth, and degree of risk aversion) but more importantly of the fundamentals of other emerging economies. Therefore this paper provides a theoretical formalization that is the base for and endogenous explanation of the contagion of financial crises. The model shows that whenever a country suffers a domestic shock that forces it to default in its debts, this domestic shock will affect the investor's wealth and therefore her tolerance of risk, producing a contagion of the crisis in those countries whose fundamentals are not solid enough. Also, even when the crisis in a country does not force such country to default, the domestic shock affects the overall riskiness of the investor's portfolio, forcing her to rebalance it. In this case the investor moves away from countries that are ``too'' risky towards countries that are relatively solid, exhibiting a behavior consistent with the observed phenomena denominated as ``flight to quality''. Quantitatively, the application of the model to the case of the Argentinean default of $2001$ and the posterior contagion of the crisis to the neighboring country Uruguay shows that the model with financial links is not only consistent with the business cycle behavior of emerging economies considered but it is also superior to models that do not contemplate such links in the following dimensions: i.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets; ii.) the model explains endogenously the positive correlation between the economies' sovereign bonds spreads, debt flows and consumptions, and iii.) the model exhibits the behavior observed in the data of higher volatility and comovement of the series of emerging economies during periods of volatility in financial markets prompted by the crisis in some emerging country.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 20795.

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Date of creation: 06 Feb 2009
Date of revision: 06 Feb 2010
Handle: RePEc:pra:mprapa:20795

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Keywords: Contagion; Default; Sovereign Debt; Financial Crises; Sovereign bond spreads;

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References

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  1. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
  2. Lagunoff, Roger & Schreft, Stacey L., 2001. "A Model of Financial Fragility," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 220-264, July.
  3. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  4. Igor Livshits & James MacGee & Michele Tertilt, 2006. "Accounting for the Rise in Consumer Bankruptcies," University of Western Ontario, Economic Policy Research Institute Working Papers 20066, University of Western Ontario, Economic Policy Research Institute.
  5. Taimur Baig & Ilan Goldfajn, 2000. "The Russian default and the contagion to Brazil," Textos para discussão 420, Department of Economics PUC-Rio (Brazil).
  6. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  7. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2008. "Heterogeneous borrowers in quantitative models of sovereign default," Working Paper 07-01, Federal Reserve Bank of Richmond.
  8. Kenneth M. Kletzer and Brian D. Wright., 1998. "Sovereign Debt as Intertemporal Barter," Center for International and Development Economics Research (CIDER) Working Papers C98-100, University of California at Berkeley.
  9. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2007. "A quantitative theory of unsecured consumer credit with risk of default," Working Papers 07-16, Federal Reserve Bank of Philadelphia.
  10. T. Todd Smith & Garry J. Schinasi, 1999. "Portfolio Diversification, Leverage, and Financial Contagion," IMF Working Papers 99/136, International Monetary Fund.
  11. Jafarey, Saqib & Rupert, Peter, 2001. "Limited Commitment, Money, and Credit," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 22-58, July.
  12. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
  13. Kristin Forbes, 2000. "The Asian Flu and Russian Virus: Firm-level Evidence on How Crises are Transmitted Internationally," NBER Working Papers 7807, National Bureau of Economic Research, Inc.
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  15. Reinhart, Carmen & Kaminsky, Graciela, 1998. "Financial crises in Asia and Latin America: Then and now," MPRA Paper 13877, University Library of Munich, Germany.
  16. Sandra Lizarazo & Jose Maria Da-Rocha, 2009. "Money, Credit and Default," Working Papers 0908, Centro de Investigacion Economica, ITAM.
  17. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  18. Richard Cantor & Frank Packer, 1996. "Determinants and impact of sovereign credit ratings," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 37-53.
  19. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets," Working Papers 2006-02, Banco de México.
  20. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
  21. Bewley, Truman, 1983. "A Difficulty with the Optimum Quantity of Money," Econometrica, Econometric Society, vol. 51(5), pages 1485-504, September.
  22. Ilan Goldfajn & Taimur Baig, 1999. "Financial market contagion in the Asian crisis," Textos para discussão 400, Department of Economics PUC-Rio (Brazil).
  23. Xinshen Diao & Wenli Li & Erinc Yeldan, 2000. "How the Asian crisis affected the world economy : a general equilibrium perspective," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 35-59.
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  25. International Monetary Fund, 1999. "Sources of Contagion," IMF Working Papers 99/146, International Monetary Fund.
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Citations

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Cited by:
  1. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2008. "Heterogeneous borrowers in quantitative models of sovereign default," Working Paper 07-01, Federal Reserve Bank of Richmond.
  2. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "Debt dilution and sovereign default risk," Working Paper 10-08, Federal Reserve Bank of Richmond.
  3. Leonardo Martinez & Juan Hatchondo & Javier Bianchi, 2012. "Sovereign defaults and optimal reserves management," 2012 Meeting Papers 1125, Society for Economic Dynamics.
  4. Lizarazo, Sandra, 2010. "Default Risk and Risk Averse International Investors," MPRA Paper 20794, University Library of Munich, Germany.
  5. Leonardo Martinez & Juan Carlos Hatchondo, 2009. "A model of credit risk without commitment," 2009 Meeting Papers 978, Society for Economic Dynamics.
  6. Juan Carlos Hatchondo & Cesar Sosa-Padilla & Leonardo Martinez, 2010. "Debt dilution, overborrowing, and sovereign default risk," 2010 Meeting Papers 481, Society for Economic Dynamics.
  7. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  8. Ludwig, Maximilian, 2013. "Government Debt and Default in a Minimal State," Working Papers 30/2013, Universidade Portucalense, Centro de Investigação em Gestão e Economia (CIGE).
  9. Cristina Arellano & Yan Bai, 2013. "Linkages across Sovereign Debt Markets," NBER Working Papers 19548, National Bureau of Economic Research, Inc.
  10. Cristina Arellano & Yan Bai, 2013. "Linkages across sovereign debt markets," Staff Report 491, Federal Reserve Bank of Minneapolis.

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