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Sovereign Defaults and Banking Crises

  • Cesar Sosa-Padilla

Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers who lend to both the government and the corporate sector. When these bankers are highly exposed to government debt, a default triggers a banking crisis, which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to the 2001-02 Argentine default episode, the model is able to produce default in equilibrium at observed frequencies, and when defaults occur credit contracts sharply, generating output drops of 6% below trend, on average. Moreover, the model matches several moments of the data on macroeconomic aggregates, sovereign borrowing, and scal policy. The framework presented can also be useful for studying the optimality of fractional defaults and the political economy of domestic debt repudiation.

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File URL: http://socserv.mcmaster.ca/econ/rsrch/papers/archive/2012-09.pdf
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Paper provided by McMaster University in its series Department of Economics Working Papers with number 2012-09.

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Length: 47 pages
Date of creation: Sep 2012
Date of revision: Oct 2014
Handle: RePEc:mcm:deptwp:2012-09
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  1. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
  2. Gelos, R. Gaston & Sahay, Ratna & Sandleris, Guido, 2011. "Sovereign borrowing by developing countries: What determines market access?," Journal of International Economics, Elsevier, vol. 83(2), pages 243-254, March.
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  4. Carmen M. Reinhart, 2010. "This Time is Different Chartbook: Country Histories on Debt, Default, and Financial Crises," NBER Working Papers 15815, National Bureau of Economic Research, Inc.
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  9. Gennaioli, Nicola & Martin, Alberto & Rossi, Stefano, 2010. "Sovereign Default, Domestic Banks and Financial Institutions," CEPR Discussion Papers 7955, C.E.P.R. Discussion Papers.
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  11. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  12. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
  13. Leonardo Martinez & Juan Carlos Hatchondo & Cesar Sosa Padilla, 2011. "Debt Dilution and Sovereign Default Risk," IMF Working Papers 11/70, International Monetary Fund.
  14. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  15. Morten O. Ravn & Harald Uhlig, 2002. "On adjusting the Hodrick-Prescott filter for the frequency of observations," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 371-375.
  16. Chakraborty, Suparna, 2009. "Modeling sudden stops: The non-trivial role of preference specifications," Economics Letters, Elsevier, vol. 104(1), pages 1-4, July.
  17. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  18. Michael Kumhof & Evan Tanner, 2005. "Government Debt; A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
  19. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
  20. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises; A New Database," IMF Working Papers 08/224, International Monetary Fund.
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