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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. 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. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  3. Roger D. Lagunoff & Stacey L. Schreft, 1998. "A model of financial fragility," Research Working Paper 98-01, Federal Reserve Bank of Kansas City.
  4. Kletzer, Kenneth M. & Wright, Brian D., 1998. "Sovereign Debt as Intertemporal Barter," Center for International and Development Economics Research, Working Paper Series qt4qg3c42v, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  5. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
  6. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
  7. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Staff Report 410, Federal Reserve Bank of Minneapolis.
  8. Jafarey, Saqib & Rupert, Peter, 2001. "Limited Commitment, Money, and Credit," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 22-58, July.
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  12. 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.
  13. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
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  16. Ilan Goldfajn & Taimur Baig, 1999. "Financial market contagion in the Asian crisis," Textos para discussão 400, Department of Economics PUC-Rio (Brazil).
  17. Kaminsky, Graciela L & Reinhart, Carmen M, 1998. "Financial Crises in Asia and Latin America: Then and Now," American Economic Review, American Economic Association, vol. 88(2), pages 444-48, May.
  18. Garry J. Schinasi & R. Todd Smith, 2000. "Portfolio Diversification, Leverage, and Financial Contagion," IMF Staff Papers, Palgrave Macmillan, vol. 47(2), pages 1.
  19. Reinhart, Carmen & Kaminsky, Graciela, 2008. "The center and the periphery: The globalization of financial turmoil," MPRA Paper 14100, University Library of Munich, Germany.
  20. Richard Cantor & Frank Packer, 1996. "Determinants and impacts of sovereign credit ratings," Research Paper 9608, Federal Reserve Bank of New York.
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  25. Sandra Lizarazo & Jose Maria Da-Rocha, 2009. "Money, Credit and Default," Working Papers 0908, Centro de Investigacion Economica, ITAM.
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Citations

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Cited by:
  1. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "Debt dilution and sovereign default risk," Working Paper 10-08, Federal Reserve Bank of Richmond.
  2. Leonardo Martinez & Juan Hatchondo & Javier Bianchi, 2012. "Sovereign defaults and optimal reserves management," 2012 Meeting Papers 1125, Society for Economic Dynamics.
  3. Leonardo Martinez & Juan Carlos Hatchondo, 2009. "A model of credit risk without commitment," 2009 Meeting Papers 978, Society for Economic Dynamics.
  4. Cristina Arellano & Yan Bai, 2013. "Linkages across Sovereign Debt Markets," NBER Working Papers 19548, National Bureau of Economic Research, Inc.
  5. Juan Carlos Hatchondo & Cesar Sosa-Padilla & Leonardo Martinez, 2010. "Debt dilution, overborrowing, and sovereign default risk," 2010 Meeting Papers 481, Society for Economic Dynamics.
  6. Cristina Arellano & Yan Bai, 2013. "Linkages across sovereign debt markets," Staff Report 491, Federal Reserve Bank of Minneapolis.
  7. Lizarazo, Sandra Valentina, 2013. "Default risk and risk averse international investors," Journal of International Economics, Elsevier, vol. 89(2), pages 317-330.
  8. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  9. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2009. "Heterogeneous Borrowers In Quantitative Models Of Sovereign Default," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(4), pages 1129-1151, November.
  10. 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).

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