Liquidity Crises, Liquidity Lines and Sovereign Risk

This paper delivers a framework to quantitatively investigate the introduction of liquidity lines during a liquidity crisis. In an endogenous sovereign default model, I quantify the gains of arranging such lines by comparing simulations of the model with the simulations found when the government issues only non-state contingent bonds. I find that liquidity lines mitigate the borrowing costs and generate gains both for the government and its creditors. I also show that when the liquidity lines are introduced and the sovereign is committed not to exceed its mean debt-to-income ratio prior to liquidity lines being established, then the gains are significantly larger. These findings shed light on the current policy discussions for the utilization of liquidity lines.