Sovereign debt markets in turbulent times: Creditor discrimination and crowding-out effects |
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Institution: | 1. CREI, Universitat Pompeu Fabra, and Barcelona GSE, Spain;2. European Stability Mechanism, Luxembourg;3. Bank of Spain, Spain;1. Sao Paulo School of Economics-FGV, Brazil;2. Michigan State University, United States;1. Paris School of Economics, University of Paris 1 Panthéon-Sorbonne, and CEPR, France;2. Australian National University, CAMA, and EABCN, Australia;3. University .of Washington, CEPR, EABCN, and NBER, United States;1. Harvard University, USA;2. Bank of International Settlements, Switzerland;3. INSEAD, France;1. London Business School, Regent?s Park, London NW1 4SA, United Kingdom;2. Department of Economics, University of Leicester, Leicester LE1 7RH, United Kingdom;1. Department of Economics, University of North Carolina at Chapel Hill, 6C Gardner Hall, CB 3305, Chapel Hill, NC 27599-3305, United States;2. Department of Economics, Arizona State University, W.P. Carey School of Business, 501 E. Orange Street, Tempe, AZ 85287, United States |
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Abstract: | In 2007, countries in the euro zone 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 sector to the public sector, 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 crowding-out effects can be transmitted to other countries in the euro zone, and how they may be addressed by policies at the European level. |
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Keywords: | Sovereign debt Discrimination Crowding out Rollover crises Economic growth |
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