The impact of sovereign defaults on lending countries

This paper explores the impact of sovereign defaults on lending countries and evaluates government intervention policies in a dynamic infinite-horizon model. When banks in the lending country hold risky foreign bonds, the default risk in the foreign country has a spillover effect on the output volatility of the lending country. A macroprudential tax on the purchase of foreign bonds reduces the lending country’s exposure to foreign sovereign risk and output volatility. Households gain in welfare as a result, but bankers lose because taxes lower banks’ profitability. The effect on overall welfare is mixed, depending on which group dominates. It is beneficial ex post to implement bailout policies when the government redistributes resources from households to banks after default, but bailouts encourage banks to take on risk by holding more sovereign bonds ex ante, leading to greater output fluctuations in the lending country.