What is the effect of the fear of future sovereign default on the economy of the defaulting country? The typical sovereign default model does not address this question. In this paper we wish to explore the possibility that changing expectations about future default themselves can lead to financial stress (as measured by credit spreads) and recessionary outcomes. We exploit the "news- shock" framework to consider an environment in which sovereign debt-holders receive imperfect signals about the portion of debt that a sovereign may default on in the future. We then investigate how domestic banks can play a role in transmitting the expectation of default into a realized recession through the interaction of the domestic banks' holdings of government debt and their risk- weighted capital requirements. Our results suggest that, consistent with the data, even in the absence of actual realized government default, an increase in pessimism regarding the prospect of future default results in a rise in yields on government debt and an increase in interest rates on private domestic loans, as well as a recession in the economy.

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Keywords expectations-driven business cycles, sovereign defaults, nancial, intermediation, news shocks, business cycles, interest rate spreads, capital ad-, equacy requirements.
JEL Prices, Business Fluctuations, and Cycles (jel E3), Financial Markets and the Macroeconomy (jel E44), Financial Aspects of Economic Integration (jel F36), International Finance Forecasting and Simulation (jel F37), Macroeconomic Aspects of International Trade and Finance (jel F4), Banks; Other Depository Institutions; Mortgages (jel G21)
Series Carleton Economic Papers (CEP)
Gunn, C, & Johri, A. (2013). Fear of Sovereign Default, Banks, and Expectations-driven Business Cycles (No. CEP 13-03). Carleton Economic Papers (CEP).