Sovereign default, exit and contagion in a monetary union

Sylvester Eijffinger, Michal Kobielarz, Burak Uras

Research output: Contribution to journalArticleScientificpeer-review

Abstract

The euro area sovereign debt crisis is characterized by a simultaneous surge in the cost of borrowing for peripheral EMU countries following the Greek debt-trouble in 2008. We develop a model with optimal default and monetary-union exit decisions of a small open economy. Our model can account for the behavior of sovereign bond spreads in the eurozone with the arrival of the news of Greece potentially exiting the euro in the near future. In our theoretical framework, belonging to the monetary-union entails a strong exchange rate peg, which can be abandoned only if the country exits the union. Exit is costly and the cost of exit remains unknown until the first country leaves the union. The theoretical mechanism we explore reveals that while a high expected exit-cost could improve the credibility of a monetary union, uncertainty governing exit-cost realizations could make the monetary-union members prone to surges in interest rates when rumors of a member state exiting arise. We solve the model numerically and quantify that a Grexit-rumors type of shock can triple the default likelihood of an a-priori financially healthy member state. Our framework thus provides a novel and quantitatively important explanation for the eurozone crisis.
Original languageEnglish
Pages (from-to)1-19
JournalJournal of International Economics
Volume113
DOIs
Publication statusPublished - Jul 2018

Fingerprint

Contagion
Exit
Sovereign default
Monetary union
Costs
Rumor
Euro zone
Theoretical framework
Bond spreads
Uncertainty
Borrowing
Debt
Sovereign debt crises
Interest rates
News
Greece
Small open economy
Credibility
Sovereign bonds
Exchange rates

Keywords

  • contagion
  • monetary union
  • sovereign debt crisis
  • exit

Cite this

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Sovereign default, exit and contagion in a monetary union. / Eijffinger, Sylvester; Kobielarz, Michal; Uras, Burak.

In: Journal of International Economics, Vol. 113, 07.2018, p. 1-19.

Research output: Contribution to journalArticleScientificpeer-review

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