RATIONAL LIQUIDITY CRISES IN THE SOVEREIGN DEBT MARKET - IN SEARCH OFA THEORY

This paper studies under what circumstances creditworthy sovereign bor rowers may be denied liquidity by rational creditors. It is shown that , when the creditor side of the market consists of many small investor s, multiple rational expectations equilibria may exist. In one equilib rium, creditors' pessimistic expectations about the borrower's creditw orthiness become self-fulfilling, and the borrower experiences a liqui dity crisis. Multiple equilibria can be avoided by marketing the loan appropriately or by developing a reputation for following good policie s. Liquidity problems can also arise because international bond market s are temporarily disrupted owing to events unrelated to the borrower' s circumstances. Policy responses are discussed.