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  5. Sovereign Debt, Banking Fragility, and Trade Frictions
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Sovereign Debt, Banking Fragility, and Trade Frictions

Paper Session

Sunday, Jan. 5, 2025 10:15 AM - 12:15 PM (PST)

Hilton San Francisco Union Square, Golden Gate 6
Hosted By: American Economic Association
  • Chair: Enrique Mendoza, University of Pennsylvania

Official Sovereign Debt

Cristina Arellano
,
Federal Reserve Bank of Minneapolis
Leonardo Barreto
,
University of Minnesota

Abstract

This paper studies official sovereign debt empirically and theoretically. Official sovereign debt is more than half of the total sovereign debt in emerging markets and tends to rise during default episodes, much more than debt with private creditors. We develop a model with official and private debt where the sovereign can partially default on each of its debts. A fraction of the defaulted debt accumulates during a default episode, which resolves when the sovereign pays back its accrued obligations. We find that official debt is longer-term than private debt and more concessional. These differences across debts allow our model to rationalize the stylized facts of emerging markets. Counterfactual analysis suggests that official debt is welfare improving for indebted economies and finds the possibility of voluntary swaps of private for official debt during debt crises.

A Theory of International Official Lending

Qing Liu
,
Tsinghua University
Zanhui Liu
,
Tsinghua University
Vivian Yue
,
Emory University

Abstract

This paper develops a theoretical framework to explain the role of international
official lending. We study a repeated game model of sovereign debt in the presence
of default risk and moral hazard. First, the sovereign country can renege on the
debt. Second, lenders cannot perfectly observe whether the sovereign uses the borrowed
funds for consumption or export production. The constrained optimal allocation
(COA) prescribes imperfect insurance and provides dynamic incentives. The COA is
decentralized by a competitive equilibrium with official lending and private lending.
Numerical exercises demonstrate that official debt is countercyclical, while private debt
is procyclical. This study offers insights into the interaction between different types of
creditors and the dynamics of sovereign debt.

Sovereign Risk and Banking Fragility: A Quantitative Analysis of the Doom Loop

Luigi Falasconi
,
University of Pennsylvania
Andrew Hannon
,
European Central Bank
Caterina Mendicino
,
European Central Bank
Enrique Mendoza
,
University of Pennsylvania

Abstract

Sovereign-bank feedback loops have been central to debt crises in both advanced and emerging market economies. This paper presents a new framework for assessing the relationship between the risk of default for both banks and sovereigns, examining their mutual interaction. The model features, on one side, government safety net guarantees for financial institutions, which mitigate banking crises and reduce the severity of economic contractions. However, these guarantees take the form of contingent liabilities on the government’s balance sheet and may increase the risk of a sovereign debt crisis. On the other side, the model generates a concentration of sovereign debt on the balance sheets of the domestic banking sector increasing the risk of sovereign debt crises spilling over into banking crises. This two-way feedback loop is central to the positive and normative implications of our analysis.

World Financial Cycles and Global Trade

Yan Bai
,
University of Rochester
Minjie Deng
,
Simon Fraser University
Chang Liu
,
University of Rochester
Gabriel Mihalache
,
Ohio State University

Abstract

This paper studies the two-way interaction between trade flows and sovereign yields, empirically and in general equilibrium, with a focus on the way global trade costs shape salient patterns in the data. Our framework enables us to study the extent to which international retrenchment in the post-Brexit era of trade skepticism can account for worsening credit conditions for emerging market sovereigns. We revisit the relationship between default episodes and trade flows and the question of whether default causes or is caused by falling trade openness.

Discussant(s)
Matias Moretti
,
University of Rochester
Rishabh Kirpalani
,
University of Wisconsin-Madison
Pablo D'Erasmo
,
Federal Reserve Bank of Philadelphia
Chenyue Hu
,
University of California-Santa Cruz
JEL Classifications
  • F4 - Macroeconomic Aspects of International Trade and Finance
  • F3 - International Finance