NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Default Risk, Sectoral Reallocation, and Persistent Recessions

Cristina Arellano, Yan Bai, Gabriel Mihalache

NBER Working Paper No. 23835
Issued in September 2017
NBER Program(s):   IFM

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.

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Document Object Identifier (DOI): 10.3386/w23835

Forthcoming: Default Risk, Sectoral Reallocation, and Persistent Recessions, Cristina Arellano, Yan Bai, Gabriel Mihalache. in NBER International Seminar on Macroeconomics 2017, Frankel and Rey. 2017

 
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