We construct a two country DSGE model with a Monetary Union to show that cross-border holdings of risky sovereign debt by balance sheet constrained financial intermediaries can give rise to negative spillovers. A sovereign debt crisis in one country negatively affects the other: capital losses because of (anticipated) sovereign debt discounts reduce intermediaries’ net worth in both countries, leading to higher credit spreads and interest rates, thereby pushing down investment and output. We find that a debt-financed recapitalization of the country in sovereign debt crisis hardly alleviates financial sector problems, because the increase in intermediaries’ net worth is offset by increased capital losses on more risky sovereign debt. A recapitalization of the country without sovereign debt problems on the other hand is beneficial: there are no additional capital losses, but net worth is increased, alleviating bank balance sheet constraints. Investment and output increase with respect to the no intervention case. Our model suggests that eurozone policies should be aimed at recapitalizing and cleaning up the financial institutions in the core because these governments still have the capability of financing such a recap.

Field: Macroeconomics

Discussant: Piotr Denderski (VU)