Default Risk, Coordination Failure, and Emerging Economy Business Cycles

Business cycles in emerging market economies are systematically associated with countercyclical changes in their country spreads: namely, in bad times, countries borrow less at higher spread and default more frequently. To examine this prominent aspect of emerging countries, I develop a small open economy model of sovereign default in a dynamic stochastic general equilibrium setting. In this model, defaults arise not only from bad output shocks, but also from coordination failures among international lenders. When a country’s level of debt lies within a certain output-contingent interval, a loss of lenders’ confidence in the country’s repayment ability leads to a debt roll-over failure, triggering a self-fulfilling default. The default probability explicitly depends on the strategic incentives and the beliefs of market participants. In a quantitative analysis of Argentina, the model accounts for several features of the economy: defaults are only weakly correlated with outputs, net exports are highly volatile, and consumption fluctuates significantly more than output. The model also predicts that the country’s level of borrowing is sensitive to small changes in the probability of coordination failure. ∗I am indebted to my advisors Harold Cole, Christian Hellwig, and Hanno Lustig for their advice and encouragements. I am also grateful to Mark Wright for his comments and suggestions on the earlier version of this paper. I also thank the participants of macroeconomics proseminar at UCLA. Correspondence: Department of Economics, University of California, Los Angeles, P.O. Box 951477, Los Angeles, CA, 900951477, Email: [email protected]