Sovereign Risk, Private Credit, and Stabilization Policies

In this paper we examine the impact of bailout policies in small open economies that are subject to financial frictions. We extend standard endogenous default models in two ways. First, we augment the government’s choice set with a bailout option. In addition to the standard choice of defaulting or repaying the debt, a government can also choose to ask for a third-party bailout, which comes at a cost of an imposed borrowing limit. Second, we introduce financial frictions and a financial intermediation channel, which tie conditions on the private credit market to the conditions on the sovereign credit market. This link has been very strong in European countries during the recent sovereign crisis. We find that the existence of a bailout option reduces sovereign spreads and, through the described link, private credit rates as well. The implementation of a rescue program reduces output losses and increases welfare, measured in consumption equivalent terms. Moreover, bailout benefits emerge even when a government only has the option of asking for a bailout, but does not take advantage of it.