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Making sovereign debt safe with a financial stability fund

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  • Liu, Yan
  • Marimon, Ramon
  • Wicht, Adrien

Abstract

We develop an optimal design of a Financial Stability Fund that coexists with the international debt market. The sovereign can borrow defaultable bonds on the private international market, while having with the Fund a long-term contingent contract subject to limited enforcement constraints. The Fund contract does not have ex ante conditionality, but requires an accurate country-specific risk-assessment (DSA), accounting for the Fund contract. The Fund periodically announces the level of liabilities the country can sustain to achieve the constrained efficient allocation. The Fund is only required minimal absorption of the sovereign debt, but it must provide insurance (Arrow-securities) to the country. Furthermore, with the Fund all sovereign debt is safe independently of the seniority structure; however, for the Fund, seniority may require a greater minimal absorption than a pari passu regime. We calibrate our model to the Italian economy and show it would have had a more efficient path of debt accumulation with the Fund.

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  • Liu, Yan & Marimon, Ramon & Wicht, Adrien, 2023. "Making sovereign debt safe with a financial stability fund," Journal of International Economics, Elsevier, vol. 145(C).
    • Handle: RePEc:eee:inecon:v:145:y:2023:i:c:s0022199623001204
    DOI: 10.1016/j.jinteco.2023.103834
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    More about this item

    Keywords

    Recursive contracts; Limited enforcement; Debt stabilization; Debt overhang; Safe assets; Seniority structure;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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