Liquidity crises, liquidity lines and sovereign risk

This paper investigates the trade-offs of introducing an extra line of credit in an emergency situation with a quantitative sovereign default model. I show that temporary access to these lines for up to 3 percent of mean annual income during low liquidity periods yields long-term effects with a lower cost of borrowing but with incentives to accumulate higher debt. Permanent access, however, has only short-lived effects because temporal arrangement better completes the markets and induces market discipline as the government worries about rollover risk once the low liquidity period ends. I also present in an event analysis that Mexico’s arrangement of swap lines with the Federal Reserve amid the global financial crisis in 2008 helped avoid a potential debt crisis.