Staff Report 491

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Linkages across Sovereign Debt Markets

Cristina Arellano - Senior Research Economist
Yan Bai

Published October 11, 2013

Abstract
We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders with concave payoffs. A foreign default increases incentives to default at home because it makes new borrowing more expensive and defaulting less costly. Foreign defaults tighten home bond prices because they lower lenders' payoffs. Foreign defaults make home default less costly by lowering future recoveries, because countries can extract more surplus if they renegotiate simultaneously. In our model, the home country may default only because the foreign country is defaulting. This dependency arises during fundamental foreign defaults, where the foreign country defaults because of high debt and low income, and also during self-fulfilling defaults, where both countries default only because the other is defaulting. The simultaneity in defaults induces a correlation in interest rate spreads across countries. The model can rationalize some of the recent economic events in Europe.


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