Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out

Abstract

In 2007, countries in the Euro periphery were enjoying stable growth, low deficits, and low spreads. Then the financial crisis erupted and pushed them into deep recessions, raising their deficits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sectors, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowdingout effects can be transmitted to other countries in the Eurozone, and how they may be addressed by policies at the European level.

Bank and Sovereign Risk Feedback Loops

“…They document a stronger reallocation away from domestic lending in the periphery. A similar crowding out effect is present in Broner et al (2014), who present a battery of stylized facts for the euro area, including both an increase in sovereign bond holdings by banks and a simultaneous drop in financing to the private sector. 15 Corporate borrowers and banks may face a sudden stop after a sovereign default even if their exposure to government bonds is limited.…”

“…Their message is positive and highlights the ability of bank rescue operations to improve macroeconomic performance. Still, while they show that bank rescues raise investment, in line with the evidence in Broner et al (2014) or Popov and Van Horen (2013), they find that sovereign debt purchases by domestic banks lead to a crowding out of private investment. Gray and Jobst (2011) and Gray et al (2013) present a less benign exercise showing the potentially high impact on fiscal risk associated to the existence of contingent liabilities.…”

“…Remarkably, since the inception of the OMT, the correlation is back to its pre-crisis value. 21 Relatedly, Broner et al (2014) narrative of the crisis breaks the euro area into a core and a periphery. A a set of regressions is presented where the feedback effect from one risk to the other is (i) allowed to depend on the specific periods described in Table 1 and (ii) allowed to differ between core and peripheral countries provides further intuition about the dynamic relation of the risk indicators.…”

“…1 On the other hand, pro-cyclical fiscal policy and a lack of competitiveness led to a sovereign debt crisis in Greece. As foreign investors withdrew, banks became major holders of public debt (Broner et al, 2014). Successive sovereign downgrades, ending in a sovereign debt restructuring, contributed to the collapse of the Greek banking sector.…”

Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets

“…16 Moreover, the economic downturn may be reinforced by a credit crunch, as banks reduce lending due to capital losses and the increase in uncertainty that comes with the default. Popov and Van Horen (2013), Broner et al (2014) and Gennaioli et al (2014b) support the view that large sovereign 5 exposures can limit banks' ability to extend loans to the private sector, triggering a credit crunch. These papers document a stronger reallocation away from domestic lending in the euro area periphery during the recent crisis.…”