Working Paper: NBER ID: w23835
Authors: Cristina Arellano; Yan Bai; Gabriel Mihalache
Abstract: 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 inflows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a reflection of the scarcity of traded goods. We find that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.
Keywords: sovereign debt; sectoral reallocation; persistent recessions; default risk
JEL Codes: E3; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sovereign debt crises (F34) | large and persistent declines in economic activity (E32) |
| sovereign debt crises (F34) | declines in output in nontradable sectors (F69) |
| sovereign debt crises (F34) | negligible declines in output in tradable sectors (F69) |
| 1% increase in bond spreads (E43) | 3% decline in annual growth rates for sectors with zero tradedness (F69) |
| 1% increase in bond spreads (E43) | 15% increase in growth rates for sectors with high tradedness (F10) |
| adverse domestic shock (H84) | increased likelihood of default (G33) |
| increased likelihood of default (G33) | limits on capital inflows and reduces investment (F21) |
| limits on capital inflows and reduces investment (F21) | reallocating capital toward the traded sector (O24) |
| sovereign debt crises (F34) | real exchange rate depreciation (F31) |
| decline in aggregate output (E23) | persistent output below trend (E32) |