Sovereign defaults and liquidity crises☆

a r t i c l e i n f o Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. The conventional view is that the domestic turmoil is the consequence of foreign retaliation, although there is no clear empirical evidence on " classic " default penalties. This paper emphasizes, instead, a direct link between sovereign defaults and liquidity crises building on two natural assumptions: (i) government bonds represent a source of liquidity for the domestic private sector and (ii) the government cannot discriminate between domestic and foreign creditors in the event of default. In this context, external debt emerges even in the absence of classic penalties, and government default is countercyclical, triggers a liquidity crunch, and amplifies output volatility. In addition, a reform that involves a substitution of government bonds with privately-sourced liquidity instruments could backfire by restricting governments' access to foreign credit. Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. Borensztein and Panizza (2008) show that sovereign default was, in fact, a good predictor of a banking crisis in many emerging countries during the period from 1980 to 2000. 1 The conventional view interprets domestic turmoil as an indirect consequence of foreign retaliation, for example trade sanctions or exclusion from international financial markets. 2 Yet, this interpretation is controversial. First, there is no clear-cut empirical evidence supporting the application of " classic " penalties. 3 Second, in recent sovereign crises (e.g., Argentina 2001 and Russia 1998) government default had a direct " balance-sheet " effect on domestic financial institutions, which were major holders of public debt (Mishkin, 2006). In this paper, I study the direct connection between sovereign defaults and liquidity crises abstracting from external penalties. The model builds on two natural assumptions for emerging markets. First, public debt represents a source of liquidity for the private sector. Specifically, domestic firms need to refinance their projects in the future but are not able to access spot credit markets due to limited enforcement of creditors' rights. Firms then save in government bonds, either directly or indirectly through the banking sector, to hoard a reserve of liquidity. This aspect of the model is consistent with the negative correlation observed in the data between creditors' rights protection and banks' holdings of government debt. 4 Second, the government cannot discriminate between domestic and foreign bondholders in the event of default. This …