infonet-economy

Sovereign debt crises in emerging markets are usually associated with liquidity and banking
crises. The conventional view is that the domestic financial turmoil is the consequence of foreign retaliation, although there is no clear empirical evidence on "classic" default penalties.
This paper emphasizes instead a direct link between sovereign defaults and liquidity crises,
building on two natural assumptions: (i) government bonds represent a source of liquidity
for the domestic private sector; (ii) the government cannot discriminate between domestic
and foreign creditors in the event of default. In this context, external debt emerges even in
the absence of classic penalties and government default is counter cyclical, triggers a liquidity
crunch, and amplifies output volatility. In addition, a financial reform that involves a substitution of government bonds with privately-sourced liquidity instruments could backfire by restricting government's access to foreign credit.