Sovereign default in a multi-country economy

This paper presents a model of endogenous sovereign default in a multi-country economy, where international investors' risk aversion affects the dynamic interactions between country-specific fundamentals, default risk, and bond prices. Risk averse investors perceive government bonds as imperfect substitutes, so that they seek to diversify their sovereign debt portfolios according to an endogenous constant-elasticity-of-substitution (CES) demand function. Further, I argue that the elasticity of substitution between bonds is inversely related to the degree of intratemporal risk aversion affecting investors’ portfolio decisions as well as directly related to the level of financial integration in the union-wide sovereign debt market. In an analytical assessment, I show that, with different values of the model parameters, a higher degree of intratemporal risk aversion (i.e. a lower elasticity of substitution between bonds) determines larger volatility of government bond yields, due to a higher sensitivity to movements of country-specific fundamentals. The model hence suits extensive empirical evidence on the euro-area sovereign debt market, pointing at investors' sentiments as a major determinant of the shift in yield dynamics occurred in the wake of the euro sovereign debt crisis. In a quantitative assessment, the model is calibrated to Greek data before and during the sovereign debt crisis. First, simulated government bond yields and macroeconomic fundamentals match relevant features of sample dynamics between 2002 and 2012. Second, when the model is fed with Greek data from the first quarter of 2002 up to the second quarter of 2010, results show that, in a low-risk aversion (i.e. high elasticity) scenario, the model dynamics of Greek sovereign debt spreads resemble the data in the pre-crisis period, characterized by smooth changes and a very low sensitivity to movements in fundamentals. Conversely, in a high-risk aversion (i.e. low elasticity) scenario, the model can successfully replicate data during the crisis, when the decline in output generated a sharp increase in the volatility of Greek sovereign debt spreads.