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Legal enforcement, public supply of liquidity and sovereign risk

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  • Filippo Brutti

Abstract

Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises within the economy. This connection is suggested by both anecdotical and empirical evidence. The conventional view is that the domestic financial turmoil is caused by foreign creditors' retaliation. Yet, there is no clear-cut evidence supporting the existence of 'classic' default penalties (e.g., trade sanctions or exclusion from international capital markets). This paper then proposes a novel mechanism linking sovereign defaults with liquidity and banking crises without any intervention of foreign creditors. The model considers a standard unwillingness-to-pay problem assuming that: (i) the enforcement of private contracts is limited and, as a result, public debt represents a source of liquidity; (ii) the government cannot discriminate between domestic and foreign agents. In this setting, the prospect of drying up the private sector's liquidity restores the ex-post incentive to pay of the government without any need to assume foreign penalties. Nonetheless, liquidity crises might arise when economic conditions deteriorate and the government chooses opportunistically to default in order to avoid the repayment of foreign agents. The interaction between the enforcement friction and sovereign risk is then exploited to study the implications on international capital flows and legal and institutional domestic reforms.

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  • Filippo Brutti, 2010. "Legal enforcement, public supply of liquidity and sovereign risk," IEW - Working Papers 464, Institute for Empirical Research in Economics - University of Zurich.
  • Handle: RePEc:zur:iewwpx:464
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    Cited by:

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    2. Jaume Ventura & Fernando Broner, 2008. "Rethinking the effects of financial liberalization," 2008 Meeting Papers 747, Society for Economic Dynamics.
    3. Nicola Gennaioli & Alberto Martin & Stefano Rossi, 2014. "Sovereign Default, Domestic Banks, and Financial Institutions," Journal of Finance, American Finance Association, vol. 69(2), pages 819-866, April.
    4. Irina Balteanu & Aitor Erce, 2018. "Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 66(4), pages 617-664, December.
    5. Carlos Eduardo Gonçalves & Bernardo Guimaraes, 2012. "Optimal fiscal adjustment and the commitment-to-forgive issue," Working Papers, Department of Economics 2012_01, University of São Paulo (FEA-USP).
    6. Aitor Erce, 2012. "Selective sovereign defaults," Globalization Institute Working Papers 127, Federal Reserve Bank of Dallas.
    7. Aitor Erce Domiguez, 2010. "Debtor Discrimination During Sovereign Debt Restructurings," 2010 Meeting Papers 1324, Society for Economic Dynamics.
    8. Benhima, Kenza, 2013. "Financial integration, capital misallocation and global imbalances," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 324-340.
    9. Irina Balteanu & Aitor Erce, 2014. "Bank crises and sovereign defaults in emerging markets: exploring the links," Globalization Institute Working Papers 184, Federal Reserve Bank of Dallas.
    10. Irina Balteanu & Aitor Erce, 2014. "Banking crises and sovereign defaults in emerging markets: exploring the links," Working Papers 1414, Banco de España.

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    More about this item

    Keywords

    Legal institutions; liquidity; sovereign risk; financial dependence;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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