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Francisco Roldán
Sovereign debt crises coincide with deep recessions. I propose a model of sovereign debt that rationalizes large contractions in economic activity via an aggregate-demand amplification mechanism. The mechanism also sheds new light on the response of consumption to sovereign risk, which I document in the context of the Eurozone crisis. By explicitly separating the decisions of households and the government, I examine the interaction between sovereign risk and precautionary savings. When a default is likely, households anticipate its negative consequences and cut consumption for self-insurance reasons. Such shortages in aggregate spending worsen economic conditions through nominal wage rigidities and boost default incentives, restarting the vicious cycle. I calibrate the model to Spain in the 2000s and find that about half of the output contraction is caused by default risk. More generally, sovereign risk exacerbates volatility in consumption over time and across agents, creating large and unequal welfare costs even if default does not materialize.
Francisco Roldán

decisions were made in a coordinated way. In the canonical model, output and spreads are correlated because recessions increase default incentives: given debt prices, the presence of sovereign risk does not affect the economy unless a default actually happens. To investigate the interaction between precautionary motives and sovereign risk, I consider a small open economy in which heterogeneous households, subject to uninsurable idiosyncratic income risk, can save as well as choose their exposure to government debt. This Bewley setup results in distributions of wealth

Chang Ma and Mr. Fabian Valencia

and those from income smoothing. The first channel emerges from the change in default incentives induced by the reduction in downside risks to income through put options. The second channel is similar to Lucas (1987) , in which lower income fluctuations translate into a smoother consumption path, which increases welfare for risk averse agents. We conclude that about 90 percent of the welfare gains stem from the borrowing costs channel. Compared to the economy without hedging, risk spreads on debt are 19 basis points lower in the hedging economy. 3 We also find

Chang Ma and Mr. Fabian Valencia
Over the past two decades, Mexico has hedged oil price risk through the purchase of put options. We examine the resulting welfare gains using a standard sovereign default model calibrated to Mexican data. We show that hedging increases welfare by reducing income volatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent to a permanent increase in consumption of 0.44 percent with 90 percent of these gains stemming from lower risk spreads.
Miss Zhanwei Z. Yue and Mr. Enrique G. Mendoza
Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments.
International Monetary Fund. Research Dept.

can choose to renege on their obligations and default on their firm’s foreign debt. Individual default is associated with a punishment, in the form of a temporary productivity loss and restriction from further accessing the financial market. Naturally, a firm which is large, as measured by the size of its installed capital, suffers a large total output loss from the punishment of a reduced productivity. A more painful punishment for default implies that a large firm can commit to higher levels of debt before entrepreneurial default incentives are triggered. A larger

Mr. Marco Gross, Mr. Thierry Tressel, Xiaodan Ding, and Eugen Tereanu

regarding labor and credit markets . These features include the details of unemployment benefit plans, for example, regarding replacement rates and the duration of benefits, the share of variable/fixed rate loans, and the extent to which house price developments influence PDs through strategic default incentives. Unemployment benefits and fixed interest rate shares differ notably across countries and have a significant impact on credit risk dynamics. The extent to which mortgages are limited recourse matters especially in the U.S., where strategic default incentives

Mr. Marco Gross, Mr. Thierry Tressel, Xiaodan Ding, and Eugen Tereanu
We present an analysis of the sensitivity of household mortgage probabilities of default (PDs) and loss given default (LGDs) on unemployment rates, house price growth, interest rates, and other drivers. A structural micro-macro simulation model is used to that end. It is anchored in the balance sheets and income-expense flow data from about 95,000 households and 230,000 household members from 21 EU countries and the U.S. We present country-specific nonlinear regressions based on the structural model simulation-implied relation between PDs and LGDs and their drivers. These can be used for macro scenario-conditional forecasting, without requiring the conduct of the micro simulation. We also present a policy counterfactual analysis of the responsiveness of mortgage PDs, LGDs, and bank capitalization conditional on adverse scenarios related to the COVID-19 pandemic across all countries. The economics of debt moratoria and guarantees are discussed against the background of the model-based analysis.