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A solution to the default risk-business cycle disconnect

  • Enrique G. Mandoza
  • Vivian Z. Yue

Models of business cycles in emerging economies explain the negative correlation between country spreads and output by modeling default risk as an exogenous interest rate on working capital. Models of strategic default explain the cyclical properties of sovereign spreads by assuming an exogenous output cost of default with special features, and they underestimate debt-output ratios by a wide margin. This paper proposes a solution to this default risk-business cycle disconnect based on a model of sovereign default with endogenous output dynamics. The model replicates observed V-shaped output dynamics around default episodes, countercyclical sovereign spreads, and high debt ratios, and it also matches the variability of consumption and the countercyclical fluctuations of net exports. Three features of the model are key for these results: (1) working capital loans pay for imported inputs; (2) imported inputs support more efficient factor allocations than when these inputs are produced internally; and (3) default on the foreign obligations of firms and the government occurs simultaneously.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 924.

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Date of creation: 2008
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Handle: RePEc:fip:fedgif:924
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  1. Gabriel Cuadra & Horacio Sapriza, 2007. "Fiscal Policy and Default Risk in Emerging Markets," Working Papers 2007-03, Banco de México.
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  7. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
  8. Carlos O. Arteta & Galina Hale, 2006. "Sovereign debt crises and credit to the private sector," Working Paper Series 2006-21, Federal Reserve Bank of San Francisco.
  9. Gita Gopinath & Oleg Itskhoki & Roberto Rigobon, 2010. "Currency Choice and Exchange Rate Pass-Through," American Economic Review, American Economic Association, vol. 100(1), pages 304-36, March.
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  12. Cristina Arellano & Narayana R. Kocherlakota, 2008. "Internal Debt Crises and Sovereign Defaults," NBER Working Papers 13794, National Bureau of Economic Research, Inc.
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  15. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
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  18. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
  19. Gelos, R. Gaston & Sahay, Ratna & Sandleris, Guido, 2011. "Sovereign borrowing by developing countries: What determines market access?," Journal of International Economics, Elsevier, vol. 83(2), pages 243-254, March.
  20. Felipe Meza & Erwan Quintin, 2005. "Financial crises and total factor productivity," Center for Latin America Working Papers 0105, Federal Reserve Bank of Dallas.
  21. Ran Bi, 2008. "“Beneficial†Delays in Debt Restructuring Negotiations," IMF Working Papers 08/38, International Monetary Fund.
  22. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
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  24. Sandra Lizarazo & Jose Maria Da-Rocha, 2009. "Money, Credit and Default," Working Papers 0908, Centro de Investigacion Economica, ITAM.
  25. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
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