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Default risk and income fluctuations in emerging economies

  • Arellano, Cristina

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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  2. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
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  22. Broner, Fernando A & Lorenzoni, Guido & Schmukler, Sergio, 2007. "Why Do Emerging Economies Borrow Short Term?," CEPR Discussion Papers 6249, C.E.P.R. Discussion Papers.
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  24. R. Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries; What Determines Market Access?," IMF Working Papers 04/221, International Monetary Fund.
  25. Zhang, Harold H, 1997. " Endogenous Borrowing Constraints with Incomplete Markets," Journal of Finance, American Finance Association, vol. 52(5), pages 2187-2209, December.
  26. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  27. Harold L. Cole & Patrick J. Kehoe, 1997. "Reviving reputation models of international debt," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 21-30.
  28. Andrew Atkeson, 2010. "International lending with moral hazard and risk of repudiation," Levine's Working Paper Archive 200, David K. Levine.
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