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Sovereign Default, Foreign Exchange-in-Advance Constraints, and Endogenous Default Costs

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  • Alok Johri

Abstract

I build a sovereign default model in which importing economies must cover intermediate imports using accumulated foreign exchange (reserves). This occasionally-binding constraint: explains why imports and production fall during defaults; complements models with simultaneous holdings of debt and reserves; generates endogenous default costs that increase with output; and motivates defaults for reserve conservation. The model is less reliant on ad-hoc default costs prevalent in prior quantitative sovereign default models seeking to match the data. Simulations from the model reveal average output losses in default that are greater than 10%, and a 17% fall in imports and a large reserve-to-gdp ratio.

Suggested Citation

  • Alok Johri, 2025. "Sovereign Default, Foreign Exchange-in-Advance Constraints, and Endogenous Default Costs," Department of Economics Working Papers 2025-06, McMaster University.
    • Handle: RePEc:mcm:deptwp:2025-06
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    References listed on IDEAS

    as
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    Keywords

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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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