Illiquidity in Sovereign Debt Markets

Abstract

We study sovereign debt and default policies when credit and liquidity risk are jointly determined. To account for both types of risks we focus on an economy with incomplete markets, limited commitment, and search frictions in the secondary market for sovereign bonds. We quantify the effect of liquidity on sovereign spreads and welfare by performing quantitative exercises when our model is calibrated to match key features of the Argentinean default in 2001. From a positive point of view, we find (a) that a substantial portion of sovereign spreads is due to a liquidity premium, and (b) the liquidity premium helps to resolve the "credit spread puzzle," by generating high mean spreads while maintaining a low default frequency. From a normative point of view, we find that reductions in secondary market frictions improve welfare.

Keywords: Credit Risk, Liquidity Risk, Sovereign Debt, Open Economies

JEL Classification: D83, E32, E43, E44, F34, G12, O11