We study debt policy of emerging economies accounting for credit and liquidity risk. To account for credit risk we study an incomplete markets model with limited commitment and exogenous costs of default following the quantitative literature of sovereign debt. To account for liquidity risk, we introduce search frictions in the market for sovereign bonds. In our model, default and liquidity will be jointly determined. This permits us to structurally decompose spreads into a credit and liquidity component. To evaluate the quantitative performance of the model we perform a calibration exercise using data for Argentina. We find that introducing liquidity risk does not harm the overall performance of the model in matching key moments of the data (mean debt to GDP, mean sovereign spread and volatility of sovereign spread). At the same time, the model endogenously generates bid ask spreads, that can match those for Argentinian bonds in the period of analysis. Regarding the structural decomposition, we find that the liquidity component can explain up to 50 percent of the sovereign spread during bad times; when the sovereign is not close to default, the liquidity component is negligible. Finally, regarding business cycle properties, the model matches key moments in the data. Joint with Yu Xu.

Link to paper.