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Sovereign Risk Contagion

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Listed:
  • Cristina Arellano
  • Yan Bai
  • Sandra Lizarazo

Abstract

We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders’ pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).

Suggested Citation

  • Cristina Arellano & Yan Bai & Sandra Lizarazo, 2017. "Sovereign Risk Contagion," NBER Working Papers 24031, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:24031
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    References listed on IDEAS

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    1. Arellano, Cristina & Kocherlakota, Narayana, 2014. "Internal debt crises and sovereign defaults," Journal of Monetary Economics, Elsevier, vol. 68(S), pages 68-80.
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    7. Lizarazo, Sandra Valentina, 2013. "Default risk and risk averse international investors," Journal of International Economics, Elsevier, vol. 89(2), pages 317-330.
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    Cited by:

    1. Cristina Arellano & Yan Bai & Gabriel Mihalache, 2018. "Inflation Targeting with Sovereign Default Risk," Department of Economics Working Papers 18-14, Stony Brook University, Department of Economics.
    2. Eberhardt, Markus, 2018. "(At Least) Four Theories for Sovereign Default," CEPR Discussion Papers 13084, C.E.P.R. Discussion Papers.
    3. Jean-Marc Fournier & Manuel Bétin, 2018. "Limits to government debt sustainability in middle-income countries," OECD Economics Department Working Papers 1493, OECD Publishing.
    4. Juan Morelli & Diego Perez & Pablo Ottonello, 2019. "Global Banks and Systemic Debt Crises," 2019 Meeting Papers 644, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • G01 - Financial Economics - - General - - - Financial Crises

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