Belief Regimes and Sovereign Debt Crises∗

Sovereign debt spreads occasionally exhibit sharp, large spikes in spreads over riskfree bonds. We document that these movements are only weakly correlated with movements in domestic output and are frequently followed by reductions in the face value of debt outstanding. Motivated by this evidence, we propose a quantitative model with long-term bonds and three sources of risk: fluctuations in the growth of domestic income; movements in the risk premia associated with default risk; and shifts in creditor “beliefs” regarding the actions of other creditors. We show that the shifts in creditor beliefs directly play an important role in generating default risk, but also amplify the impact of shocks to fundamentals. Interestingly, persistent changes to risk premia have a negligible impact on spreads, and an increase in risk premium may even lead to a decline in spreads. The latter reflects that a higher risk premium provides discipline regarding future debt issuances. More generally, the sovereign borrowing decisions are quantitatively sensitive to equilibrium bond prices. Even large, relatively unexpected shocks to creditor beliefs have only a modest effect on spreads as the government responds by aggressively deleveraging. ∗The views expressed here are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. We thank Manuel Amador for numerous helpful comments. We also thank our discussant Luigi Paciello.