Sovereign Default, Foreign Exchange-in-Advance Constraints, and Endogenous Default Costs

Alok Johri

Department of Economics Working Papers from McMaster University

Abstract: I build a sovereign default model in which importing economies must cover intermediate imports using accumulated foreign exchange (reserves). This occasionally-binding constraint: explains why imports and production fall during defaults; complements models with simultaneous holdings of debt and reserves; generates endogenous default costs that increase with output; and motivates defaults for reserve conservation. The model is less reliant on ad-hoc default costs prevalent in prior quantitative sovereign default models seeking to match the data. Simulations from the model reveal average output losses in default that are greater than 10%, and a 17% fall in imports and a large reserve-to-gdp ratio.

Keywords: Sovereign default; imports and default costs; sovereign spreads; foreign exchange-in-advance constraints; international reserves (search for similar items in EconPapers)
JEL-codes: E32 F34 F41 G15 H63 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2025-08
New Economics Papers: this item is included in nep-dge and nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:mcm:deptwp:2025-06

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