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

Author

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  • Park, JungJae

Abstract

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.

Suggested Citation

  • Park, JungJae, 2013. "Contagion of Sovereign Default Risk: the Role of Two Financial Frictions," MPRA Paper 55197, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:55197
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    File URL: https://mpra.ub.uni-muenchen.de/55197/3/MPRA_paper_55197.pdf
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    References listed on IDEAS

    as
    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.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Yan Bai & Cristina Arellano, 2012. "Linkages across sovereign debt markets," 2012 Meeting Papers 414, Society for Economic Dynamics.
    2. Welburn, Jonathan William & Hausken, Kjell, 2015. "A Game-Theoretic Model with Empirics of Economic Crises," UiS Working Papers in Economics and Finance 2015/7, University of Stavanger.
    3. Jonathan William Welburn & Kjell Hausken, 2017. "Game Theoretic Modeling of Economic Systems and the European Debt Crisis," Computational Economics, Springer;Society for Computational Economics, vol. 49(2), pages 177-226, February.
    4. David Greenlaw & James D. Hamilton & Peter Hooper & Frederic S. Mishkin, 2013. "Crunch Time: Fiscal Crises and the Role of Monetary Policy," NBER Working Papers 19297, National Bureau of Economic Research, Inc.
    5. Cristina Arellano & Yan Bai & Sandra Lizarazo, 2017. "Sovereign Risk Contagion," NBER Working Papers 24031, National Bureau of Economic Research, Inc.
    6. Sasha Indarte, 2017. "Contagion via Financial Intermediaries in Pre-1914 Sovereign Debt Markets," 2017 Meeting Papers 1141, Society for Economic Dynamics.
    7. Welburn, Jonathan W. & Hausken, Kjell, 2015. "A game theoretic model of economic crises," Applied Mathematics and Computation, Elsevier, vol. 266(C), pages 738-762.

    More about this item

    Keywords

    Contagion; Sovereign Default; DSGE;

    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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