Sudden Stops and Sovereign Defaults

Recent debt crises in Europe have highlighted the role of asymmetric information about fiscal shocks in accounting for sudden hikes in country risk. We develop a model where such asymmetry of information combined with the persistence of tax shocks can produce a sudden inward shift in the supply of loanable funds to a sovereign. Unlike previous models, such a sudden stop (SS) shows up in bond prices but not in borrowing flows until outright default materializes. The key trigger is an unexpected and large external financing tapping by the sovereign: under asymmetric information, even if the tapping is successful and net borrowing goes up, this signals a persistent negative shock to tax revenues and hence to debt repayment capacity, which raises spreads and in turn lowers the cost of a subsequent default. Under various parametrizations, the model generates a separating equilibrium where the SS preceds both the default and the eventual drop in net inflows, as well as a pooling equilibrium in which spreads stay put and the SS will not preceed a sovereign default. We provide evidence that such a parcimonious model captures rather well the main stylized facts surrounding several recent and past episodes of sudden stops and sovereign defaults.