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Sovereign debt markets in turbulent times: creditor discrimination and crowding-out effects

  • Fernando Broner

    (CREI, Universitat Pompeu Fabra and Barcelona GSE)

  • Alberto Martin

    (CREI, Universitat Pompeu Fabra and Barcelona GSE)

  • Jaume Ventura

    (CREI, Universitat Pompeu Fabra and Barcelona GSE)

  • Aitor Erce

    (Banco de España and European stability mechanism)

In 2007, countries in the euro periphery were enjoying stable growth, low deficits and low spreads. Then the financial crisis erupted and pushed them into deep recession, raising their deficits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sector, reducing investment and deepening the recession even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowding-out effects can be transmitted to other countries in the euro zone, and how they may be addressed by policies at the European level.

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Paper provided by Banco de España & Working Papers Homepage in its series Working Papers with number 1402.

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Length: 69 pages
Date of creation: Feb 2014
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Handle: RePEc:bde:wpaper:1402
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  30. Oren Sussman & Alexander Guembel, 2005. "Sovereign Debt Without Default Penalties," OFRC Working Papers Series 2005fe17, Oxford Financial Research Centre.
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