Default Risk and Aggregate Fluctuations in Emerging Economies

Sovereign default in emerging countries is accompanied by interest rates spikes, deep recessions, and sharp real exchange rate devaluations. This paper develops a two sector small open economy model to study default risk and its interaction with output, consumption and real exchange rates. 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 default premia 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 several features of the Argentinian economy. The model can account for the recent default episode and the dynamics observed prior to default: higher interest rate premia, capital outflows, real exchange rate depreciation, and collapses in consumption. An important implications of the model is that economies with relatively small tradable sectors have higher incentives to default on dollar denominated debt and thus have larger default probabilities. JEL Classification: E44, F32, F34