Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out

IMF Working Papers, December 27, 2013

Source details

Canonical URL: Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out

In 2007, countries in the Euro periphery were enjoying stable growth, low deficits, and low spreads.
The financial crisis erupted and pushed these countries into deep recessions, raising their deficits and debt levels.
By 2010, they were facing severe debt problems.
Observed during the crisis: spreads increased and the share of the debt held by domestic creditors increased.
Credit was reallocated from the private to the public sectors, reducing investment and deepening recessions.

The authors propose a simple model of sovereign risk in which debt can be traded in secondary markets.
Two key ingredients:
- Creditor discrimination: in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones, providing incentives for domestic purchases of debt.
- Crowding-out effects: private borrowing is limited by financial frictions, so domestic debt purchases displace productive investment.

Domestic purchases of sovereign debt:
- Reduce growth and welfare.
- May lead to self-fulfilling crises.
Crowding-out effects can be transmitted to other countries in the Eurozone.
The combination of creditor discrimination and crowding-out explains reallocation of credit from private to public sectors and the observed increase in domestic debt holdings during the crisis.

Addressing crowding-out effects may require policies at the European level (the paper discusses how they may be addressed by policies at the European level).
Policy focus implied by the analysis:
- Mitigate creditor discrimination across domestic and foreign investors.
- Alleviate financial frictions that limit private borrowing to avoid displacement of productive investment.
- Coordinate European-level interventions to prevent cross-country transmission of crowding-out.

Source: "Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out", IMF Working Papers 2013, 270 (2013).