Working Paper: NBER ID: w22694
Authors: Luigi Bocola; Alessandro Dovis
Abstract: This paper uses the information contained in the joint dynamics of government’s debt maturity choices and interest rate spreads to quantify the importance of self-fulfilling expectations in sovereign bond markets. We consider a model of sovereign borrowing featuring endogenous debt maturity, risk averse lenders and self-fulfilling rollover crises á la Cole and Kehoe (2000). In this environment, interest rate spreads are driven by economic fundamentals and by expectations of future self-fulfilling defaults. These two sources of default risk have contrasting implications for the debt maturity choices of the government. Therefore, they can be indirectly inferred by tracking the evolution of the maturity structure of debt during a crisis. We fit the model to the Italian debt crisis of 2008-2012, finding that 12% of the spreads over this episode were due to rollover risk. Our results have implications for the effects of the liquidity provisions established by the European Central Bank during the summer of 2012.
Keywords: sovereign debt; self-fulfilling crises; interest rate spreads; debt maturity
JEL Codes: E44; F34; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| self-fulfilling expectations of lenders regarding government solvency (F34) | fluctuations in interest rate spreads (E43) |
| heightened rollover risks (R48) | lengthening of debt maturity (F34) |
| economic fundamentals (E25) | shortening of debt maturity (G32) |
| rollover risk component (G32) | fluctuations in interest rate spreads (E43) |
| liquidity provisions by the ECB (E52) | expectations of future bailouts (G28) |
| expectations of future bailouts (G28) | observed interest rate spreads (E43) |