Default Risk, Sectoral Reallocation and Persistent Recessions
Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital in?ows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by ...
Financial frictions and fluctuations in volatility
During the recent U.S. financial crisis, the large decline in economic activity and credit was accompanied by a large increase in the dispersion of growth rates across firms. However, even though aggregate labor and output fell sharply during this period, labor productivity did not. These features motivate us to build a model in which increased volatility at the firm level generates a downturn but has little effect on labor productivity. In the model, hiring inputs is risky because financial frictions limit firms' ability to insure against shocks that occur between the time of production and ...
Firm dynamics and financial development
This paper studies the impact of cross-country variation in financial market development on firms? financing choices and growth rates using comprehensive firm-level datasets. We document that in less financially developed economies, small firms grow faster and have lower debt to asset ratios than large firms. We then develop a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. We parameterize the model to the firms? financial structure in the data and show that financial restrictions can account for the ...
Sovereign risk and firm heterogeneity
This paper studies the recessionary effects of sovereign default risk using firm-level data and a model of sovereign debt with firm heterogeneity. Our environment features a two-way feedback loop. Low output decreases the tax revenues of the government and raises the risk that it will default on its debt. The associated increase in sovereign interest rate spreads, in turn, raises the interest rates paid by firms, which further depresses their production. Importantly, these effects are not homogeneous across firms, as interest rate hikes have more severe consequences for firms that are in need ...
Renegotiation Policies in Sovereign Defaults
This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing ...
Appendix for Financial Frictions and Fluctuations in Volatility
This appendix contains five sections. Section 1 provides details for the comparative statics exercise performed in the simple example. Section 2 discusses extending the model to allow firms to default on the wages for managers. Section 3 describes the firm-level and aggregate data. Section 4 contains the details of the computational algorithm. Finally, Section 5 reports the results for our model with a lower labor elasticity.
Linkages across sovereign debt markets
We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders with concave payoffs. A foreign default increases incentives to default at home because it makes new borrowing more expensive and defaulting less costly. Foreign defaults tighten home bond prices because they lower lenders' payoffs. Foreign defaults make home default less costly by lowering future recoveries, because countries can extract more surplus if they renegotiate simultaneously. In our model, ...
Sovereign Risk Contagion
We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the ...
Deadly Debt Crises: COVID-19 in Emerging Markets
The COVID-19 epidemic in emerging markets risks a combined health, economic, and debt crisis. We integrate a standard epidemiology model into a sovereign default model and study how default risk impacts the ability of these countries to respond to the epidemic. Lockdown policies are useful for alleviating the health crisis but they carry large economic costs and can generate costly and prolonged debt crises. The possibility of lockdown induced debt crises in turn results in less aggressive lockdowns and a more severe health crisis. We find that the social value of debt relief can be ...
Fiscal Austerity during Debt Crises
This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the ...