Three Sisters: The Interlinkage between Sovereign Debt, Currency and Banking Crises

CEPR Policy Paper March 2013 (full PDF)
By Sylvester C. W. Eijffinger and Bilge Karataş

The sovereign debt default and the linkages from banking and currency crisis have been rarely explored in the crisis literature. This study attempts to dive into this unexplored area by applying panel data binary choice model on a sample with 20 emerging countries having monthly observations for the years between 1985 and 2007. The non-linear linkages from currency and banking crises to sovereign defaults are explored by using the interactions of these crises with international illiquidity, appreciated real exchange rates and real international monetary policy rates. It is discovered that currency, banking and debt crises tend to occur simultaneously. Prior occurrence of a currency crisis increases the sovereign default probability through appreciated real exchange rates, and in countries with high short-term indebtedness the occurrence of banking crisis raises the probability of a debt crisis.

Inspired by the recent exposure of the advanced economies to financial crises and consequently sovereign debt repayment problems, this study explores the explanatory powers of banking and currency crises on sovereign defaults while controlling for the political and macroeconomic factors by applying monthly data. In uncovering the non-linear linkages from banking and currency crises to sovereign defaults, the interactions of international illiquidity with banking and currency crisis, overvalued exchange rates and real international interest rates with currency crises are included. The results indicate that banking, currency and debt crises have a tendency to occur simultaneously; an increase in the indebtedness of the public sector, overvalued exchange rates and financial as well as political riskiness of a country plays a role in predicting sovereign default. Currency crisis increases the debt crisis probability through appreciated real exchange rates, and for some observations through tight international lending, and international illiquidity indirectly increases default probability if a banking crisis happens in three monthtime prior to a sovereign default. International illiquidity coupled with currency crisis does not have any significance on the probability of a debt crisis.

The study contributes to the existing literature with the application of high-frequency data in estimations having monthly starting dates of sovereign debt rises and introducing non-linear effects of the currency and banking crises on sovereign defaults. The role of political disunity is clearly present in the analysis increasing the uncertainty of the sovereign actions and leading to a rise in the probability of default.

Sylvester C. W. Eijffinger, CentER, European Banking Center Tilburg University and CEPR
Bilge Karataş, CentER and the Graduate School of Economics, Tilburg University, and ASIS, Avians University of Applied Sciences

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