Dynamics of investment, debt, and default

Abstract

This paper proposes a sovereign default model with long-term debt and endogenous output and investment that simultaneously accounts for default episodes and business cycles in emerging economies. In response to positive productivity shocks, risk premia fall and the sovereign borrows to finance investment. When adverse productivity shocks make international borrowing expensive, the sovereign responds by rolling over debt and reducing investment. This causes output to fall and the debt-output ratio to increase, and default occurs if the negative shocks continue long enough. Consequently, the model generates first an increase and then a decrease in investment, consumption, and output prior to default, as in the data. These relationships between productivity, spreads, investment, and borrowing also make the model consistent with many features of small open economy business cycles such as countercyclical spreads and net exports. While capital has nontrivial effects on the incentive to default, increased capital almost always reduces risk premia in equilibrium.