Self_fulfilling Debt Crises: A Quantitative Analysis

This paper uses the information contained in the joint dynamics of government’s debt maturity choices and interest rate spreads to quantify the importance of self- fulfilling expectations in sovereign bond markets. We consider a model of sovereign borrowing featuring endogenous debt maturity, risk averse lenders and self-fulfilling rollover crises aÌ la Cole and Kehoe (2000). In this environment, interest rate spreads are driven by economic fundamentals and by expectations of future self-fulfilling defaults. These sources of default risk have contrasting implications for the government’s debt maturity choices. Therefore, they can be indirectly inferred by tracking the evolution of the maturity structure of debt during a crisis. We fit the model to the Italian debt crisis of 2008-2012, finding that rollover risk accounted for 20% of the movements in spreads over this episode. Our results have implications for the effects of the liquidity provisions established by the European Central Bank during the summer of 2012.