Sovereign default and capital accumulation

Abstract

This paper introduces endogenous capital accumulation into an otherwise standard quantitative sovereign default model à la Eaton and Gersovitz (1981). We find that conditional on a level of debt, default incentives are U-shaped in the capital stock: the economy with too small or too large amounts of capital is likely to default. Even without using an ad-hoc output cost of default, the calibrated model generally well matches business cycle facts of emerging economies and generates defaults in “good” and “bad” times, with a frequency of 25.5% and 74.5%, respectively, consistent with Tomz and Wright (2007)’s empirical findings. Simulation results show that the economy defaults in good times when it has “overinvested” in capital during booms before default.