Contagion of Sovereign Default: the Role of Two Financial Frictions

This paper develops a quantitative general equilibrium model of sovereign default with heterogeneous agents to account for spillover of default risk across countries. Borrowers (sovereign governments) and foreign lenders (investors) in the model face financial frictions, which endogenously determine each agent's credit condition. Due to lack of enforcement in sovereign debt, sovereign governments' borrowing constraints are endogenous to their incentives to default. On the other hand, foreign lenders who hold a portfolio of sovereign debts face a collateral constraint that limits their leverage of investment in sovereign debt. When the collateral constraint for investors binds due to a decrease in the value of collateral, triggered by a high default risk for one country, credit constrained investors ask for liquidity premiums even to countries in which there is no worsening of domestic fundamentals. This increase in the cost of borrowing, in turn, increases incentives to default for the other countries with normal fundamentals, further constraining investors in obtaining credit through a decrease in the value of collateral. The interplay of each agent's credit condition generates a vicious cycle through which we observe spread of default risk across countries. In quantitative studies, the model is calibrated to Greece and Spain and predicts that (1) Spain's default rate, conditional on Greece's default, increases about three times compared to Spain's unconditional default rate, and that (2) cross-country correlation in sovereign spreads increases significantly during a crisis period. The model's predictions are consistent with the recent European debt crisis.