Sovereign debt crises and cross-country assistance

Dr. Christian Grisse and Gisle J. Natvik

Issue
2018-15

Pages
21

JEL classification
F34

Keywords
Sovereign default, self-fulfilling expectations, bailout

Year
2018

We provide a theoretical study of the interplay between cross-country assistance and expectations-driven sovereign debt crises. A self-interested "safe" country may choose to assist a "risky" country that is prone to default. Investors internalize the potential for assistance when lending to fragile countries. If the safe country is not able to commit to or rule out cross-country transfers, assistance only improves the equilibrium outcomes if the risky country is fundamentally insolvent and cannot handle its debt even at the risk-free interest rate. If a default requires pessimistic expectations, an incentive-compatible assistance policy has adverse side effects.