Contagion of Sovereign Default Risk: The Role of Two Financial Frictions.

Abstract

This paper develops a quantitative general equilibrium model of sovereign default with heterogeneous agents to account for spillover of default risk across countries. Borrowers (sovereign governments) and foreign lenders (investors) in the model face financial frictions, which endogenously determine each agent's credit condition. Due to lack of enforcement in sovereign debt, borrowing constraints for the governments are endogenous to incentives to default for the governments. On the other hand, investors who hold a portfolio of sovereign debts face a collateral constraint that limits their leverage of investment in sovereign debts. When the collateral constraint for investors binds due to a decrease in the value of collateral, triggered by a high default risk for one country, credit constrained investors ask for liquidity premiums even to countries in which there is no worsening of domestic fundamentals. This increase in the cost of borrowing, in turn, increases incentives to default for other countries with normal fundamentals, further constraining investors in obtaining credit through a decrease in the value of collateral. The interplay of each agent's credit condition generates a bad spiral through which we observe spread of default risk across countries. In a quantitative analysis, the model is calibrated to Greece and Spain, and predicts (1) that cross-county correlation in sovereign spreads between Greece and Spain increases significantly during a crisis period, and (2) that Spain's default rate, conditional on Greece' default, increases about three times compared to Spain's unconditional default rate. The model's predictions are consistent with the recent European debt crisis.⇤ I am extremely grateful to Charles Engel for his constant guidance and support. I also thank Dean Corbae, Kenneth West,

Modelling Monetary and Fiscal Governance in the Wake of the Sovereign Debt Crisis in Europe

“…Aguiar and Gopinath [19], JungJae [20] and Arellano [21] even study sovereign default issues in dynamic quantitative frameworks. However, to my knowledge, this paper addresses for the first time these issues within a tractable model.…”

A game theoretic model of economic crises

“…We endogenously determine all production through the players' strategic choices. The budget constraint is (32) where N hmcnt and N f l cnt reflect the cumulative sum of lump sum transfers (tax payments) made to the government by households and firms and transfers made from the government to households and firms.…”

“…Given a single country, c 1 , with n h equivalent households (Lemma 2), n f equivalent firms (Lemma 3), and no other players, country c 1 s best response follows from max (27), the market clearing condition for goods in (30), the capital law of motion in (31), the country budget constraint in (32), and the equations in Lemmas 2 and 3.…”

“…Country c 1 invests I c 1 t , bounded above by a 15% absorptive capacity rate [31]. A mixed-integer nonlinear program (MINLP) is developed in GAMS (gams.com) to solve Lemma 4, using household utility in (11) and (12), production, Y c 1 t , in (27), the goods market clearing condition in (30), the capital law of motion for K c 1 t in (31), the country budget constraint in (32), and household consumption, C hnt , in (33) to find country c 1 's optimal strategy to maximize utility. Furthermore, in solving Lemma 4, we assume that country c 1 has the sole objective of maximizing social welfare (i.e.…”

Sovereign Risk Contagion

“…In the context of sovereign debt, our paper is related to the contemporaneous work by Park (2013). He studies contagion in a model similar to ours in which multiple borrowers trade with risk-averse lenders who are subject to capital requirements.…”