Sovereign Default, Trade, and Terms of Trade

Abstract

Sovereign defaults are associated with income and trade reductions and terms-of-trade deterioration. This paper develops a two-country model to study the interactions between income, trade, terms of trade, and foreign-debt default risk and default events. Such default risk and events are costly because they adversely affect the demand for a borrower country’s intermediate goods exports and its income. Consequently, trade flows change due to the income loss and consumption home bias. The defaulter’s terms of trade also deteriorate endogenously, which accelerates its income and trade losses. The model produces procyclical imports, exports, terms of trade, and other empirical features of emerging countries’ business cycles and default episodes.

Spillovers from one country’s sovereign debt to CDS (credit default swap) spreads of others during the European crisis: a spatial approach

“…Understanding the transmission channels that lead to cross-country contagion is important. Most attention so far has been dedicated to cross-country risk transmission through financial linkages (see for example Kallestrup et al 2016;De Bruyekere et al 2013;Dungey and Renoult 2018) and a limited number of studies are on the real channel (Gorea and Radev 2014;Gu 2021). We show that a real channel, trade linkage, is important.…”

Emerging Markets Bond Index Performance and Sovereign Default: The Case of Ecuador

“…It is worth mentioning that the correlation between macroeconomic fundamentals and sovereign risk is a two-way dynamic relationship, whereby sovereign default might affect the performance of macroeconomic indicators. Along these lines, the literature shows that after a default episode, indicators related to the external sector (for example, terms of trade and exports) suffer deterioration in the short term due to a reduction in the relative external demand for goods of the defaulting country (Gu, 2021). For Ecuador, despite possessing substantial natural resources and having periods of strong growth, macroeconomic vulnerabilities, particularly its dependency on oil revenues and susceptibility to external shocks given that it is a dollarized economy, 1 have historically undermined its economic stability and thus exacerbated its sovereign risk.…”

Gains from trade and the sovereign bond market

“…Speaking from the sovereign debt literature, there is a number of prior studies incorporating international trade in a model of sovereign debt (e.g., Mendoza and Yue, 2012;Cuadra and Sapriza, 2006;Asonuma, 2014;and Gu, 2018). For example, Cuadra and Sapriza (2006) explore the impact of trade openness and terms of trade shocks on a sovereign's incentive to default or repay.…”

“…In their model, an exogenously given terms of trade deterioration triggers a decline in output, leading to a smaller incentive to raise taxes to repay its debt, resulting in a default. Asonuma (2014) and Gu (2018) also propose models to study mechanisms a sovereign default leads to a real exchange rate depreciation and an income loss. Our focus is crucially different from these prior studies.…”