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Illiquidity in sovereign debt markets

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  • Passadore, Juan
  • Xu, Yu

Abstract

We study sovereign debt and default policies when credit and liquidity risk are jointly determined. To account for both types of risks, we focus on an economy with incomplete markets, limited commitment, and search frictions in the secondary market for sovereign bonds. We quantify the effect of liquidity on sovereign spreads and welfare by performing quantitative exercises when our model is calibrated to match key features of the Argentinean default in 2001. From a positive point of view, we find (a) that a substantial portion of sovereign spreads is due to a liquidity premium, and (b) the liquidity premium helps to resolve the “credit spread puzzle” by generating high average spreads while maintaining a low default frequency. From a normative point of view, we find that reductions in secondary market frictions improve welfare.

Suggested Citation

  • Passadore, Juan & Xu, Yu, 2022. "Illiquidity in sovereign debt markets," Journal of International Economics, Elsevier, vol. 137(C).
    • Handle: RePEc:eee:inecon:v:137:y:2022:i:c:s0022199622000502
    DOI: 10.1016/j.jinteco.2022.103618
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    Cited by:

    1. Kaldorf, Matthias & Röttger, Joost, 2023. "Convenient but risky government bonds," Discussion Papers 15/2023, Deutsche Bundesbank.
    2. Chaumont, Gaston & Gordon, Grey & Sultanum, Bruno & Tobin, Elliot, 2024. "Sovereign debt and credit default swaps," Journal of International Economics, Elsevier, vol. 150(C).
    3. Florent Kanga GBONGUE & Lambert N’Galadjo BAMBA, 2023. "Le modèle hybride de la structure par terme des primes souveraines de crédit et de liquidité dans la zone UEMOA," Region et Developpement, Region et Developpement, LEAD, Universite du Sud - Toulon Var, vol. 57, pages 101-145.
    4. Liu, Ailan & Wang, Zhixuan & Wang, Ping, 2024. "Official or unofficial? extreme bounds analysis on the determinants of sovereign default," The North American Journal of Economics and Finance, Elsevier, vol. 72(C).
    5. Janbaz, M. & Hassan, M.K. & Floreani, J. & Dreassi, A., 2024. "Liquidity pressure and the sovereign-bank diabolic loop," International Review of Economics & Finance, Elsevier, vol. 93(PA), pages 1039-1057.

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