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Contagion of Sovereign Default Risk: the Role of Two Financial Frictions

Listed author(s):
  • Park, JungJae

This paper develops a quantitative general equilibrium model of sovereign default with heterogeneous agents to account for spillover of default risk across countries. Borrowers (sovereign governments) and foreign lenders (investors) in the model face financial frictions, which endogenously determine each agent’s credit condition. Due to lack of enforcement in sovereign debt,borrowing constraints for the governments are endogenous to incentives to default for the governments. On the other hand, investors who hold a portfolio of sovereign debts face a collateral constraint that limits their leverage of investment in sovereign debts. When the collateral constraint for investors binds due to a decrease in the value of collateral, triggered by a high default risk for one country, credit constrained investors ask for liquidity premiums even to countries in which there is no worsening of domestic fundamentals. This increase in the cost of borrowing,in turn, increases incentives to default for other countries with normal fundamentals, further constraining investors in obtaining credit through a decrease in the value of collateral. The interplay of each agent’s credit condition generates a bad spiral through which we observe spread of default risk across countries. In a quantitative analysis, the model is calibrated to Greece and Spain, and predicts (1) that cross-county correlation in sovereign spreads between Greece and Spain increases significantly during a crisis period, and (2) that Spain’s default rate, conditional on Greece’ default, increases about three times compared to Spain’s unconditional default rate. The model’s predictions are consistent with the recent European debt crisis.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 55197.

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Date of creation: 02 Jan 2013
Handle: RePEc:pra:mprapa:55197
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  1. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  2. Yan Bai & Cristina Arellano, 2012. "Linkages across sovereign debt markets," 2012 Meeting Papers 414, Society for Economic Dynamics.
  3. 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.
  4. Choueiri, Nada, 2002. "A model of contagious currency crises with application to Argentina," Journal of International Money and Finance, Elsevier, vol. 21(3), pages 435-457, June.
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