Flight-to-quality debt crises

Canhui Hong
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Canhui Hong: Shanghai U. of Finance and Economics

No 166, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: I characterize risk averse lenders' optimal bond holdings under which flight-to-quality crises can arise when there are large differences in borrowing countries' future default risks, and do this within a dynamic, stochastic general equilibrium model. In this paper, there is a substitution effect between bonds issued by different countries because they are competing with each other on international borrowing. The relative fundamentals, rather than the absolute fundamentals, determine the magnitude of the substitution effect, and thus the direction of lenders' cross-border capital movements. Specifically, when the difference in countries' fundamentals is large enough, international lenders would like to move toward countries with relatively low future default risks, which improves these countries' borrowing conditions and deteriorates other countries'. Furthermore, the safer countries accommodate lenders' capital movements by issuing more debt, which reduces the borrowing resources available to other countries, further intensifies the difficulties faced by countries with deteriorated borrowing conditions, and may finally force these countries to default. Such forces were quantitatively important in explaining the empirical evidence from the recent European Debt Crisis: European peripheries had difficulty raising funds in international markets, while in countries such as Germany, and the United States, the yields declined and the debt positions rose since 2010.

Date: 2018
New Economics Papers: this item is included in nep-dge
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