Contagion of Sovereign Default Risk: the Role of Two Financial Frictions∗

This paper develops a quantitative general equilibrium model of sovereign default with heterogenous 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, Jaiver Bianchi, Brent Bundick, Juan Hatchondo, Matteo Iacoviello, Ricardo Nunes, Toshihiko Mukoyama, Vivian Yue, and seminar participants at the workshop at the Board of Governors of the Federal Reserve System and the brown bag seminars at UW-Madison for helpful comments. This paper was being written while I was staying at the Board of Governors as a dissertation intern. I am also grateful for their hospitality during my stay. All errors are mine. †Department of Economics, University of Wisconsin-Madison, 1180 Observatory Dr., Madison WI 53706. Email: [email protected]. Webpage:https://sites.google.com/site/suhyoondad/