Self-fulfilling crises and country solidarity

Abstract

Sovereign risk premia reflect investors’ beliefs for the equilibrium and off –equilibrium actions of international agents. This paper investigates the international dimension of self-fulfilling sovereign debt crises and characterizes self-interested bailouts (solidarity) and contagion. A credible bailout guarantee by a partner country or international agency can lower a debtor country’s borrowing costs and reduce the probability of belief driven default. However, time consistency undermines an international agent’s ability to commit to intervention. Investors internalise the probability that a bailout never materializes and this endogenously increases its cost. Hence solidarity will generally be insufficient to rule out non-fundamental equilibria, explaining why high sovereign debt yields can persist despite guarantees. When countries are heavily indebted, expectations of default in one country’s debt market can result in the default of its economic partner. Moreover, while large international agents are able to resolve the coordination failure, in contrast to the market, they internalise spillover costs of default and cannot credibly enforce repayment. Introducing information asymmetries results in novel on-equilibrium debt dynamics.