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Default risk and income fluctuations in emerging economies

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Arellano, Cristina

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Abstract

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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 7867.

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Date of creation: 2008
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Handle: RePEc:pra:mprapa:7867

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Find related papers by JEL classification:
F34 - International Economics - - International Finance - - - International Lending and Debt Problems
F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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  3. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics. [Downloadable!]
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  17. Cristina Arellano & Ananth Ramanarayanan, 2006. "Default and the Term Structure in Sovereign Bonds," 2006 Meeting Papers 299, Society for Economic Dynamics.
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  19. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March. [Downloadable!] (restricted)
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  20. Zhang, Harold H, 1997. " Endogenous Borrowing Constraints with Incomplete Markets," Journal of Finance, American Finance Association, vol. 52(5), pages 2187-2209, December. [Downloadable!] (restricted)
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  24. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969. [Downloadable!] (restricted)
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    Other versions:
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