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Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.

Default risk and income fluctuations in emerging economies

Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are
higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina
such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.

/pdf/default-risk-and-income-fluctuations-in-emerging-economies-3uwetnmpe6.pdf

Default Risk and Income Fluctuations in Emerging Economies

An Inquiry into the Nature and Effects of the Paper Credit of Great Britain

Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

/pdf/a-general-equilibrium-model-of-sovereign-default-and-2t8y4pn173.pdf

A General Equilibrium Model of Sovereign Default and Business Cycles

Sovereign default, interest rates and political uncertainty in emerging markets ☆

All Matlab and C++ programs necessary to produce the results of the article. There is also a Excel spreadsheet with Mexican data.

Code and data files for "Fiscal Policy and Default Risk in Emerging Markets"

https://www.richmondfed.org/~/media/richmondfedorg/publications/research/working_papers/2009/pdf/wp09-1.pdf

Fiscal policy and default risk in emerging markets

Emerging economies tend to experience larger fluctuations in their terms of trade, countercyclical interest rates and more default episodes than developed countries. These structural features might suggest a relevant role for world prices in driving country spreads. This paper studies the role of terms of trade shocks in inducing output fluctuations and countercyclical spreads using a stochastic dynamic general equilibrium model of a small open economy. The model predicts that default incentives and default premia are higher in recessions, as observed in the data. In a quantitative exercise, the model matches various features of emerging economies and can account for the dynamics of default episodes in these markets.

/pdf/sovereign-default-terms-of-trade-and-interest-rates-in-7uj35sccf8.pdf

Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets

The intensification of the global financial crisis, especially as of September 2008, had a significant negative effect on Mexico, which faced two shocks of considerable magnitude. First, the global economic recession, particularly that of the United States, led to a drop in Mexico’s exports and a deterioration in its terms of trade. Second, the climate of extreme risk aversion among international investors and the global deleveraging process significantly constrained access to international financial markets.

/pdf/the-global-financial-crisis-and-policy-response-in-mexico-3u7pt4nj71.pdf

Gabriel Cuadra

Papers

Sovereign default, interest rates and political uncertainty in emerging markets ☆

Code and data files for "Fiscal Policy and Default Risk in Emerging Markets"

Fiscal policy and default risk in emerging markets

Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets

The global financial crisis and policy response in Mexico