Default risk, sectoral reallocation, and persistent recessions

• Published in: Journal of international economics Vol. 112; pp. 182 - 199
• Main Authors: Arellano, Cristina, Bai, Yan, Mihalache, Gabriel
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.05.2018
• Subjects: Capital accumulation; European debt crisis; Real exchange rate; Sovereign default with production economy; Traded and nontraded production; Traded and nontraded production; Real exchange rate; Capital accumulation; Sovereign default with production economy; F3; European debt crisis; E3
• ISSN: 0022-1996; 1873-0353
• DOI: 10.1016/j.jinteco.2018.01.004

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.