Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. The conventional view is that such domestic financial turmoil is caused by foreign retaliation, as trade sanctions or exclusion from international financial markets. Yet, this interpretation is controversial. First, there is no clear-cut empirical evidence supporting the application of “classic” penalties. Second, in recent sovereign crises (e.g. Argentina 2001 and Russia 1998) government default had a direct “balance-sheet” effect on domestic financial institutions, since a large fraction of public debt was held domestically (see Mishkin (2006)). In this paper, I study the connection between sovereign defaults and liquidity crises in absence of external penalties.
The model builds on two natural assumptions for emerging markets. First, public debt represents a source of liquidity for the private sector. Indeed, limited enforcement restricts the access to spot credit markets and induces firms to save in government bonds (either directly or indirectly through the banking sector) as a financial buffer that can be drawn in case of unexpected investment opportunities. This is consistent with the negative correlation between creditor rights protection and banks’ holdings of government debt observed in the data. Second, the government cannot discriminate between domestic and foreign bond holders in the event of default. This assumption, which stems from the increasing integration of domestic financial markets, is consistent with the large haircuts suffered by domestic financial institutions on their government debt holdings observed in recent debt crises.
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What determines the yield differentials between bonds? Even though research has shown that the moments of bonds’ return distribution and liquidity typically both play a role, we still understand imperfectly the relative importance of these two determinants and their possible interactions.
The European Monetary Union (EMU) offers a particularly good arena to examine these issues and sharpen our understanding, because in the euro area we can observe bonds issued by several sovereign issuers, without the complications arising from different currencies and different bond conventions, but with variation in liquidity. Even though since EMU’s inception in 1999 yields on euro-area government bonds converged significantly, these bonds are still not regarded as perfect substitutes by market participants: non-negligible differences in yields across countries have remained, to different extents for different issuers and maturities, and they fluctuate over time. Even the bonds issued by AAA-rated issuers are not regarded as perfect substitutes, so that for example French bonds traded in the cash market are not seen as a perfect hedge for positions in Bund futures.
