Sovereign Default, Private Investment, and Economic Growth

Abstract

The literature on sovereign debt explains the ability of a country to borrow through various costs of a sovereign default. Existing models typically capture part of these costs as transitory drops in output of low persistence around the default. However, I show empirically that the costs of defaults seem long-lived. Even ten years after a default, GDP is roughly six percentage points lower than it would have been without a default. Output losses thus seem to be highly persistent or even permanent. Based on this observation, I develop a small open economy model that incorporates government borrowing from abroad and endogenous growth through the adoption of new varieties of intermediate goods. The model captures important stylized facts associated with sovereign borrowing, the business cycle in emerging economies and sovereign default. In the model, a sovereign default triggers a persistent loss in GDP relative to trend through a temporary reduction in technology adoption and investment. This persistence of the GDP losses adds to the cost of a default. Numerical experiments show that the long-run cost channel increases the average debt-to-GDP ratio by between 33 and 100 percent while keeping the default frequency constant or reducing it.