Working Paper: NBER ID: w24031
Authors: Cristina Arellano; Yan Bai; Sandra Lizarazo
Abstract: We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders’ pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).
Keywords: No keywords provided
JEL Codes: F3; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign default (F23) | home country's borrowing costs (F34) |
| foreign default (F23) | home default likelihood (C11) |
| foreign default (F23) | lenders' pricing kernel (G19) |
| Spanish debt crisis (F65) | Italian bond spreads (G15) |
| Italian debt crisis (F34) | Spanish bond spreads (F65) |
| defaults in one country (F31) | defaults in other countries (H69) |
| foreign debt crises (F34) | home bond spreads (G12) |