Sovereign and Private Default Risks over the Business Cycle

Abstract

Sovereign debt crises are often accompanied by deep recessions and sharp declines in external credit to the private sector. In a sample of emerging economies we find that both, sovereign and private risk premia are countercyclical and that default events are associated by strong recessions and substantial drops in imports. In our paper we present a model of a small open economy that is able to account for these empirical regularities. It includes a production sector, financing a fraction of imports by external debt, and a government which borrows internationally and taxes firms to finance expenditures for public goods. The model gives rise to endogenous private and sovereign credit spreads and a dynamic feedback mechanism from sovereign to private default risks through the endogenous response of fiscal policy to adverse productivity shocks.