Dynamics of investment, debt, and default

Abstract

How does physical capital accumulation a¤ect the decision to default in developing small open economies? We …nd that, conditional on a level of foreign indebtedness, more capital improves the sovereign's ability to meet its obligations, reducing the likelihood of default and the risk premium. This e¤ect, however, is diminishing in the stock of capital because capital also tames the severity of the contraction following default, making autarky more appealing. Access to long-term debt and costly capital adjustment are crucial for matching business cycles. Our quantitative model delivers default episodes that mimic those observed in the data.

Time‐varying Volatility, Default, and the Sovereign Risk Premium

“…Default costs for the production economy are similar in spirit to those in Gordon and Guerron‐Quintana (), and in this dimension, this article complements their work.…”

Default Risk, Sectoral Allocation, and Persistent Recessions

“…The schedule is also tighter for a smaller capital choice k and when productivity z is low. As explained in detail by Gordon and Guerrón-Quintana (2013), lower capital or lower productivity or both are associated with a lower debt repayment capacity, which increases default risk today. The bond price schedule also encodes a "Laffer curve" of borrowing and a maximum amount of capital inflow.…”

“…The model extends to two sectors the one-sector framework of Bai and Zhang (2012) and Gordon and Guerrón-Quintana (2013), who study sovereign default in an environment with capital accumulation. The two sectors produce tradable and nontradable goods that are used for consumption and investment purposes.…”

“…Asonuma (2016) documents the link between the real exchange rate and sovereign default in a pure-exchange sovereign default model. Most works in sovereign default literature abstract from capital, except for Bai and Zhang (2012) and Gordon and Guerrón-Quintana (2013). Gordon and Guerrón-Quintana focus on the effect of capital on sovereign spreads, while Bai and Zhang pay attention to the effect of default risk on international risk sharing.…”

“…We use the resulting limiting distribution of capital, debt, and productivity shocks in period 300 as the initial condition for the event. We then feed in a path of shocks such that the conditional mean aggregate output of the model reproduces the path of Spanish GDP from 2004to 2013 The shocks during the event are parallel deviations across all the 3000 paths. For reference, we also conduct the event study for the no-default reference model, where in each period we feed in the average productivity shocks recovered from the benchmark model.…”