Rational Liquidity Crises in the Sovereign Debt Market: In Search of a Theory

Abstract

This paper studies under what circumstances creditworthy sovereign borrowers may be denied liquidity by rational creditors. It is shown that, when the creditor side of the market consists of many small investors, multiple rational expectations equilibria may exist. In one equilibrium, creditors' pessimistic expectations about the borrower's creditworthiness become self-fulfilling, and the borrower experiences a liquidity crisis. Multiple equilibria can be avoided by marketing the loan appropriately or by developing a reputation for following good policies. Liquidity problems can also arise because international bond markets are temporarily disrupted owing to events unrelated to the borrower's circumstances. Policy responses are discussed.