Contagion of Sovereign Default

April 2017
Cristina Arellano, Yan Bai, Sandra Lizarazo

This paper studies the contagion of sovereign default across countries through common investors. We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders. Countries default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. Defaulting is also attractive in response to foreign defaults because the cost of rolling over the debt is higher when other countries default as these are times when the lenders’ wealth is low. Such forces are quantitatively important for generating a positive correlation of spreads and joint incidence of default. The model can rationalize some of the recent economic events in Europe as well as the historical patterns of defaults, renegotiations, and recoveries across countries.