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Contagion of Financial Crises in Sovereign Debt Markets

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  • Lizarazo, Sandra

Abstract

This paper develops a quantitative model of contagion of financial crisis and sovereign default for small open economies that cannot credibly commit to honor their international debts and have common international risk averse investors. The existence of common investors with preferences that exhibit decreasing absolute risk aversion (DARA) generates financial links between the emerging economies sovereign debt markets that help to explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices as function not only of the economy's fundamentals, the investors' characteristics (wealth, and degree of risk aversion) but more importantly of the fundamentals of other emerging economies. Therefore this paper provides a theoretical formalization that is the base for and endogenous explanation of the contagion of financial crises. The model shows that whenever a country suffers a domestic shock that forces it to default in its debts, this domestic shock will affect the investor's wealth and therefore her tolerance of risk, producing a contagion of the crisis in those countries whose fundamentals are not solid enough. Also, even when the crisis in a country does not force such country to default, the domestic shock affects the overall riskiness of the investor's portfolio, forcing her to rebalance it. In this case the investor moves away from countries that are ``too'' risky towards countries that are relatively solid, exhibiting a behavior consistent with the observed phenomena denominated as ``flight to quality''. Quantitatively, the application of the model to the case of the Argentinean default of $2001$ and the posterior contagion of the crisis to the neighboring country Uruguay shows that the model with financial links is not only consistent with the business cycle behavior of emerging economies considered but it is also superior to models that do not contemplate such links in the following dimensions: i.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets; ii.) the model explains endogenously the positive correlation between the economies' sovereign bonds spreads, debt flows and consumptions, and iii.) the model exhibits the behavior observed in the data of higher volatility and comovement of the series of emerging economies during periods of volatility in financial markets prompted by the crisis in some emerging country.

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  • Lizarazo, Sandra, 2009. "Contagion of Financial Crises in Sovereign Debt Markets," MPRA Paper 20795, University Library of Munich, Germany, revised 06 Feb 2010.
  • Handle: RePEc:pra:mprapa:20795
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    Citations

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    Cited by:

    1. Juan Carlos Hatchondo & Cesar Sosa-Padilla & Leonardo Martinez, 2010. "Debt dilution, overborrowing, and sovereign default risk," 2010 Meeting Papers 481, Society for Economic Dynamics.
    2. Brutti, Filippo & Sauré, Philip, 2015. "Transmission of sovereign risk in the Euro crisis," Journal of International Economics, Elsevier, vol. 97(2), pages 231-248.
    3. repec:eee:macchp:v2-1697 is not listed on IDEAS
    4. Lizarazo, Sandra Valentina, 2013. "Default risk and risk averse international investors," Journal of International Economics, Elsevier, vol. 89(2), pages 317-330.
    5. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
    6. Yan Bai & Cristina Arellano, 2012. "Linkages across sovereign debt markets," 2012 Meeting Papers 414, Society for Economic Dynamics.
    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.
    8. Can Sever, 2016. "Contagion: Recent Models in International Finance Literature," Bulletin of Business and Economics (BBE), Research Foundation for Humanity (RFH), vol. 5(2), pages 59-66, June.
    9. Sasha Indarte, 2017. "Contagion via Financial Intermediaries in Pre-1914 Sovereign Debt Markets," 2017 Meeting Papers 1141, Society for Economic Dynamics.
    10. Vincenzo Quadrini, 2017. "The external risks of financial integration for emerging economies," Ensayos sobre Política Económica, Banco de la Republica de Colombia, vol. 35(82), pages 18-24, April.
    11. Leonardo Martinez & Juan Carlos Hatchondo, 2008. "A model of credit risk without commitment," 2008 Meeting Papers 940, Society for Economic Dynamics.
    12. Nikolai Stähler, 2013. "Recent Developments In Quantitative Models Of Sovereign Default," Journal of Economic Surveys, Wiley Blackwell, vol. 27(4), pages 605-633, September.
    13. Juan Carlos Hatchondo & Leonardo Martinez & César Sosa-Padilla, 2016. "Debt Dilution and Sovereign Default Risk," Journal of Political Economy, University of Chicago Press, vol. 124(5), pages 1383-1422.
    14. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2009. "Heterogeneous Borrowers In Quantitative Models Of Sovereign Default," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(4), pages 1129-1151, November.
    15. Aguiar, M. & Chatterjee, S. & Cole, H. & Stangebye, Z., 2016. "Quantitative Models of Sovereign Debt Crises," Handbook of Macroeconomics, Elsevier.
    16. Ludwig, Maximilian, 2013. "Government Debt and Default in a Minimal State," Working Papers 30/2013, Universidade Portucalense, Centro de Investigação em Gestão e Economia (CIGE).
    17. João Silvestre, 2017. "Sovereign default contagion: an agent-based model approach," Working Papers Department of Economics 2017/08, ISEG - Lisbon School of Economics and Management, Department of Economics, Universidade de Lisboa.
    18. Leonardo Martinez & Juan Hatchondo & Javier Bianchi, 2012. "Sovereign defaults and optimal reserves management," 2012 Meeting Papers 1125, Society for Economic Dynamics.
    19. Ludwig, Maximilian, 2014. "How well do we understand sovereign debt crisis? Evidence from Latin America," Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100531, Verein für Socialpolitik / German Economic Association.

    More about this item

    Keywords

    Contagion; Default; Sovereign Debt; Financial Crises; Sovereign bond spreads;

    JEL classification:

    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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