A Tale of Two Countries: Sovereign Default, Exchange Rate, and Trade

This paper explores the impacts of sovereign defaults on trade and income through a real exchange rate channel, in a DSGE model of two risk-averse open economies, with production. In the model, once the borrower country defaults due to an adverse productivity shock, foreign firms reduce their imports of intermediate goods from the defaulting country, whose income consequently declines. This causes the defaulting country to adjust its consumption portfolio of domestic goods and imports according to its home bias preference, triggers a collapse in its real exchange rate, and leads to a further endogenous plummet in national income. This paper makes three main contributions. First, along business cycles, the model generates countercyclical trade balances, procyclical trade flows, and countercyclical bond spreads with a data-consistent average. Second, following a sovereign default, the model endogenously delivers sharp real exchange rate deterioration, output drops, trade balance improvements, and bilateral trade flow declines. This paper thus also studies a real exchange rate channel, through which default risks and occurrences, income, and trade interact with each other. Lastly, this model predicts lasting welfare gains for the creditor country through the real exchange rate channel, but relatively short-lived welfare losses for the borrower country and the world during and after a sovereign default.