Beiträge zur Jahrestagung des Vereins für Socialpolitik 2015: Ökonomische Entwicklung - Theorie und Politik - Session: Banks, Debt, Financial Crises G04-V3
This paper analyses empirically and theoretically the effects of uncertainty shocks on sovereign default risk. It describes a novel mechanism for non-fundamental debt crises induced by uncertainty shocks that are defined as time-varying levels of ambiguity surrounding the macroeconomic fundamental of the economy. A business cycle model with strategic sovereign default is augmented with ambiguity averse investors with multiple-priors utility. I find that uncertainty shocks increase the risk of default as perceived by worst case investors' beliefs. Sovereign and private sector interest rates rise due to a spillover channel that unfolds through the domestic banking sector. A crisis zone is characterised where worst case investors' beliefs lead to non-fundamental debt crises. The model's predictions are shown to be in line with impulse responses obtained from a VAR analysis for a panel of four Euro area countries. Specifically, the dichotomy of sovereign debt pricing in the core and periphery countries can partly be rationalised by accounting for ambiguity premia.