Theory and evidence on self-fulfilling sovereign debt crises

This work analyzes theoretically and empirically the potential self-fulfilling features of sovereign debt crisis. The theoretical model modifies Cole and Kehoe (1996, 2000) by considering that the default is partial. In the model, there are debt limits within which self-fulfilling crises may occur. The numerical results show that, within the crisis zone, up to an intermediate debt level, the optimal government policy is to run down the debt until it reaches the safe limit to avoid higher borrowing costs. Above a certain amount, however, the government chooses to run up the debt, to avoid sharp reduction in government spending. The empirical investigation assesses the determinants of the probability of default in Portugal. The model builds on Jeanne and Masson (2000) and is brought to Portuguese data using a Markov-switching regime framework. The results show that between 2000-14 two regimes subsisted: a tranquil and a crisis regime. The switch between regimes seems to be unrelated with macroeconomic fundamentals, which is interpreted as self-fulfilling jumps in the beliefs of credit markets