IMF Working Papers

A Debt Crisis with Strategic Investors: Changes in Demand and the Role of Market Power

By Ricardo Alves Monteiro

January 17, 2025

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Format: Chicago

Ricardo Alves Monteiro. "A Debt Crisis with Strategic Investors: Changes in Demand and the Role of Market Power", IMF Working Papers 2025, 019 (2025), accessed February 11, 2025, https://0-doi-org.library.svsu.edu/10.5089/9798400297984.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

This paper documents changes in investors' demand for sovereign debt during a debt crisis. Using a dataset containing individual bids on Portuguese debt auctions, I document that bid functions become more inelastic during the crisis. That is, investors require bigger drops in price to buy additional units of debt, increasing the government’s marginal cost of issuing debt. I then decompose these changes in demand into two components: a fundamental component, due to changes in the valuation of the security, and a strategic component, that arises from investors' market power. I find that, although the role of market power is negligible in normal times, it gets more pronounced leading up to and during the crisis. The government is not able to extract the full surplus from strategic investors, and, as a result, the auction mechanism loses efficiency during that period. Finally, I discuss a possible mitigation strategy. Everything else constant, the use of shorter maturities could avoid higher inefficiency costs.

Subject: Debt default, Demand elasticity, Economic theory, External debt, Financial institutions, Public debt, Treasury bills and bonds

Keywords: Debt auctions, Debt default, Default risk, Demand elasticity, Demand elasticity, Market power, Treasury bills and bonds

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