Default Risk and Income Fluctuations in Emerging Economies

by Cristina Arellano of the University of Minnesota & the Federal Reserve Bank of Minneapolis

July 2007

Abstract: 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.

JEL Classification: E44, F32, F34.

Keywords: Sovereign Default, Interest Rates, Business Cycles.

Published in: American Economic Review, Vol. 98, No. 3, (June 2008), pp. 690-712.

Previously titled: Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies

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