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Illiquidity in sovereign debt markets

Juan Passadore and Yu Xu

Journal of International Economics, 2022, vol. 137, issue C

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 average 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 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.jinteco.2022.103618

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Journal of International Economics is currently edited by Gourinchas, Pierre-Olivier and Rodríguez-Clare, Andrés

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