Illiquidity in Sovereign Debt Markets∗

[Please click here for the latest version] We study debt policy of emerging economies accounting for credit and liquidity risk. To account for credit risk we study an incomplete markets model with limited commitment and exogenous costs of default following the quantitative literature of sovereign debt. To account for liquidity risk, we introduce search frictions in the mar-ket for sovereign bonds. In our model, default and liquidity will be jointly deter-mined. This permits us to structurally decompose spreads into a credit and liquidity component. To evaluate the quantitative performance of the model we perform a cali-bration exercise using data for Argentina. We find that introducing liquidity risk does not harm the overall performance of the model in matching key moments of the data (mean debt to GDP, mean sovereign spread and volatility of sovereign spread). At the same time, the model endogenously generates bid ask spreads, that can match those for Argentinean bonds in the period of analysis. Regarding the structural de-composition, we find that the liquidity component can explain up to 50 percent of the sovereign spread during bad times; when the sovereign is not close to default, the liquidity component is negligible. Finally, regarding business cycle properties, the model matches key moments in the data. ∗We would like to thank Robert Townsend, Ivan Werning, George-Marios Angeletos and Alp Simsek for continuous support, guidance, and helpful comments on various stages of this project. We would also like to thank Nicolas Caramp, Arnaud Costinot, Athanasios Orphanides, Dejanir Silva and participants in the MIT International Lunch for helpful comments. We thank the Macro-Financial Modeling Group for financial support. All errors are our own. First Version: November 2014