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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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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. Burcu Eyigungor & Satyajit Chatterjee, 2008. "Maturity, Indebtedness and Default Risk," 2008 Meeting Papers 1001, 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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  7. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
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  9. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
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  11. Juan Carlos Hatchondo & Leonardo Martinez & Cesar Sosa-Padilla, 2014. "Debt Dilution and Sovereign Default Risk," Department of Economics Working Papers 2014-06, McMaster University.
  12. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
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  14. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
  15. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises: A New Database," IMF Working Papers 08/224, International Monetary Fund.
  16. 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.
  17. Michael Kumhof & Evan Tanner, 2005. "Government Debt: A Key Role in Financial Intermediation," IMF Working Papers 05/57, International Monetary Fund.
  18. 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.
  19. Brutti, Filippo, 2011. "Sovereign defaults and liquidity crises," Journal of International Economics, Elsevier, vol. 84(1), pages 65-72, May.
  20. Carmen M. Reinhart & Kenneth S. Rogoff, 2010. "From Financial Crash to Debt Crisis," NBER Working Papers 15795, National Bureau of Economic Research, Inc.
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  22. Chakraborty, Suparna, 2009. "Modeling sudden stops: The non-trivial role of preference specifications," Economics Letters, Elsevier, vol. 104(1), pages 1-4, July.
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