Working Paper: CEPR ID: DP7955
Authors: Nicola Gennaioli; Alberto Martin; Stefano Rossi
Abstract: We build a model where sovereign defaults weaken banks? balance sheets because banks hold sovereign bonds, causing private credit to decline. Stronger financial institutions boost default costs by amplifying these balance-sheet effects. This yields a novel complementarity between public debt and domestic credit markets, where the latter sustain the former by increasing the costs of default. We document three novel empirical facts that are consistent with our model's predictions: public defaults are followed by large private credit contractions; these contractions are stronger in countries where banks hold more public debt andfinancial institutions are stronger; in these same countries default is less likely.
Keywords: Capital flows; Financial liberalization; Institutions; Sovereign risk; Sudden stops
JEL Codes: F34; F36; G15; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Sovereign defaults (F34) | decline in private credit (G21) |
| Stronger financial institutions (G28) | decrease in likelihood of public default (H74) |
| Improvements in financial institutions (G21) | greater government borrowing (H74) |
| Public defaults (Y70) | significant contractions in private credit (G21) |
| Stronger financial institutions (G28) | amplify costs of default (G32) |