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Self-Fulfilling Sovereign Debt Crises

Author

Listed:
  • Zachary Stangebye

    (University of Notre Dame)

  • Satyajit Chatterjee

    (Federal Reserve Bank of Philadelphia)

  • Harold Cole

    (University of Pennsylvania)

  • Mark Aguiar

    (Princeton University)

Abstract

Sovereign debt spreads occasionally exhibit sharp, large spikes in spreads over risk-free bonds. We document that these movements are only weakly correlated with movements in domestic output and are frequently followed by reductions in the face value of debt outstanding. Motivated by this evidence, we propose a quantitative model with long-term bonds and three sources of risk: fluctuations in the growth of domestic income; movements in the risk premia associated with default risk; and shifts in creditor ``beliefs'' regarding the actions of other creditors. We show that the shifts in creditor beliefs directly play an important role in generating default risk, but also amplify the impact of shocks to fundamentals. Interestingly, persistent changes to risk premia have a negligible impact on spreads, and an increase in risk premium may even lead to a decline in spreads. The latter reflects that a higher risk premium provides discipline regarding future debt issuances. More generally, the sovereign borrowing decisions are quantitatively sensitive to equilibrium bond prices. Even large, relatively unexpected shocks to creditor beliefs have only a modest effect on spreads as the government responds by aggressively deleveraging.

Suggested Citation

  • Zachary Stangebye & Satyajit Chatterjee & Harold Cole & Mark Aguiar, 2016. "Self-Fulfilling Sovereign Debt Crises," 2016 Meeting Papers 360, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:360
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    References listed on IDEAS

    as
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    1. Self-Fulfilling Sovereign Debt Crises
      by Christian Zimmermann in NEP-DGE blog on 2016-08-10 22:31:41

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