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Default Risk, Sectoral Reallocation and Persistent Recessions

Staff Report 555 | Published September 11, 2017

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Cristina Arellano Assistant Director, Policy and Monetary Advisor
Yan Bai University of Rochester, NBER, and CEPR
Gabriel Mihalache Ohio State University
Default Risk, Sectoral Reallocation and Persistent Recessions


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.

Published in: _Journal of International Economics_ (Vol. 112, May 2018, pp. 182-199)