A Solution to the Default Risk-Business Cycle Disconnect

Enrique G. Mendoza · Vivian Zhanwei Yue

78 citations0/0 files storedInternational Finance Discussion Paper

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Global Financial Crisis and Policies Monetary Policy and Economic Impact Economic Theory and Policy

Abstract

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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References

1981Debt with Potential Repudiation: Theoretical and Empirical Analysis 1986Investment, Capacity Utilization and the Real Business Cycle 1986Finite state markov-chain approximations to univariate and vector autoregressions 2005Business cycles in emerging economies: the role of interest rates 2007Default Risk and Income Fluctuations in Emerging Economies 1991Real Business Cycles in a Small Open Economy 2005Defaultable debt, interest rates and the current account 2005Country spreads and emerging countries: Who drives whom?

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2016Debt Dilution and Sovereign Default Risk 2010“Unfunded liabilities” and uncertain fiscal financing 2009Sovereign Default, Private Sector Creditors and the IFIs 2008Persistent gaps and default traps 2011Financial frictions and total factor productivity: Accounting for the real effects of financial crises 2012International Government Debt

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