Rational Liquidity Crises in the Sovereign Debt Market: In Search of a Theory

IMF Working Papers, April 1, 1996

Source details

Canonical URL: Rational Liquidity Crises in the Sovereign Debt Market: In Search of a Theory

Author: Enrica Detragiache
Publication date: April 1, 1996
Research question: Under what circumstances creditworthy sovereign borrowers may be denied liquidity by rational creditors.

Market structure and equilibria
- When the creditor side of the market consists of many small investors there may be multiple rational expectations equilibria.
- In one equilibrium, creditors’ pessimistic expectations about the borrower’s creditworthiness become self-fulfilling, and the borrower experiences a liquidity crisis.
Mechanisms of liquidity problems
- Liquidity problems can also arise because of the temporary disruption of international bond markets due to events unrelated to the borrower’s circumstances.
Avoiding multiple equilibria
- Multiple equilibria can be avoided by marketing the loan appropriately or by developing a reputation for following good policies.

Market interventions and issuer actions
- Market the loan appropriately to reduce coordination failure among many small investors.
- Develop and sustain a reputation for following good policies to reduce the likelihood of self-fulfilling pessimistic equilibria.
Broader considerations
- Address temporary disruptions in international bond markets that are unrelated to borrower fundamentals as part of crisis-prevention strategies.

Subjects: Asset and liability management, Debt service, External debt, Financial crises, Financial institutions, Financial markets, Liquidity, Loans, Securities markets
Keywords: bond market, borrower issues bond, commercial paper, Debt service, debtor country, Liquidity, loan amount, loan contract, Loans, Securities markets, self-fulfilling liquidity crises, WP