Clustered sovereign defaults

Abstract

Clustered sovereign default is a recurring phenomenon, but there is a lack of quantitative models to study it. This paper introduces a quantitative framework aimed at untangling latent shocks and examining the mechanisms that precipitate clustered defaults. The model incorporates financial frictions into a sovereign default framework and accommodates global shocks that impact both borrowing countries and lenders. By jointly estimating structural parameters governing the output process of multiple countries, the global shocks are extracted. The framework’s ability to effectively capture multiple crisis episodes, such as the 1980s Latin American debt crisis, validates the joint robustness of the model and the estimation process. The framework uncovers the crucial role of global transitory shocks in producing clustered defaults, particularly when convex default costs are present. Additionally, contrary to what is commonly believed, the framework shows that the Volcker interest rate hike was not a decisive factor in the 1980s clustered default.