Motivation for the Research
World capital markets have experienced large-scale sovereign defaults on a number of occasions, the most recent being Argentina's default in 2002. While Argentina, which has experienced five default or restructuring episodes in the last 180 years, may be an extreme case, sovereign defaults occur with some frequency in emerging markets. Other characteristics of emerging markets are that defaults occur in equilibrium, interest rates and net exports are countercyclical, and interest rates and current accounts are positively correlated.
This paper develops a quantitative model of debt and default in a small open economy to match the above facts, with the aim of explaining the dynamics that produce these characteristics.
The authors develop a model of a small open economy that receives a stochastic endowment stream and trades a single good and a single asset, a one-period bond, with the rest of the world. To emphasize the distinction between the roles of transitory and permanent shocks, they present two extreme cases of their model. Model I represents the case in which the only shock is a transitory shock around a linear trend; Model II represents the case in which the trend itself is stochastic. The model is solved numerically, using the discrete state-space method.
To improve on the results, the authors augment Model II with a phenomenon observed in many default episodes-bailouts. They model bailouts as a transfer from an unmodeled third party to creditors in the case of default.
The reason a model with trend shocks performs better than one with transitory shocks is that in an environment with trend shocks, a given probability of default is associated with a smaller borrowing cost at the margin. This, in turn, rests on the fact that trend shocks have a greater impact on the propensity to default than do standard transitory shocks, making interest rates relatively less sensitive to the amount borrowed and relatively more sensitive to the realization of the shock.