Sovereign Debt, Default Risk, and the Liquidity of Government Bonds

Abstract

What is the role of liquidity in bond markets on government's debt issuances and default decisions? How do liquidity and risk premia interact in equilibrium and over the business cycle? To study these questions, this paper extends an incomplete markets model with endogenous default a la Eaton and Gersovitz (1981) by introducing liquidity frictions in sovereign bond markets. Liquidity frictions are endogenous in the model and determined by search frictions in sovereign debt markets. In order to trade, investors need to meet dealers in bond markets and, due to search frictions, trade is not guaranteed at each point in time. This assumption endogenously generates a liquidity premium on the price of debt. Moreover, search is assumed to be directed so investors willing to trade bonds face a trade-off between the amount of transaction fees that they are willing to pay and the probability of trading. As a result, in equilibrium, the optimal balance of this trade-off varies as the aggregate state of the economy evolves and liquidity varies endogenously over the business cycle. The model is used to study Greek's debt crisis in 2011-2012. We find that liquidity premium significantly contribute to debt spreads during that episode. Also, we Argentinian data to obtain results comparable to previous literature. The model is able to match liquidity measures while at the same time being able to reproduce standard business cycle moments of emerging economies.