Contagion of Sovereign Default Risk: the Role of Two Financial Frictions
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.
|Date of creation:||02 Jan 2013|
|Contact details of provider:|| Postal: Ludwigstraße 33, D-80539 Munich, Germany|
Web page: https://mpra.ub.uni-muenchen.de
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Cristina Arellano, 2008.
"Default Risk and Income Fluctuations in Emerging Economies,"
American Economic Review,
American Economic Association, vol. 98(3), pages 690-712, June.
- Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
- Yan Bai & Cristina Arellano, 2012. "Linkages across sovereign debt markets," 2012 Meeting Papers 414, Society for Economic Dynamics.
- Cristina Arellano & Yan Bai, 2013. "Linkages across Sovereign Debt Markets," NBER Working Papers 19548, National Bureau of Economic Research, Inc.
- Cristina Arellano & Yan Bai, 2013. "Linkages across sovereign debt markets," Staff Report 491, Federal Reserve Bank of Minneapolis.
- 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.
- Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
- Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
- Mark Aguiar & Gita Gopinath, 2004. "Defaultable Debt, Interest Rates and the Current Account," NBER Working Papers 10731, National Bureau of Economic Research, Inc.
- 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. Full references (including those not matched with items on IDEAS)