The Elusive Costs of Sovereign Defaults

Few would dispute that sovereign defaults entail significant economic costs, including, most notably, important output losses. However, most of the evidence supporting this conventional wisdom, based on annual observations, suffers from serious measurement and identification problems. To address these drawbacks, we examine the impact of default on growth by looking at quarterly data for emerging economies. We find that, contrary to what is typically assumed, output contractions precede defaults. Moreover, we find that the trough of the contraction coincides with the quarter of default, and that output starts to grow thereafter, indicating that default episode, rather than a further decline, seems to mark the beginning of the economic recovery. This suggests that whatever negative effects a default may have on output, they are driven by its anticipation, independently of whether or not the country ultimately decides to validate it. * We would like to thank Eduardo Cavallo and other participants in the December 2005 IPES pre-conference for usefull comments, and Mariano Alvarez for excellent research assistance. The views expressed in this paper and the authors ’ do not necessarily reflect those of the Inter-American Development Bank. 2 Hell, the last thing I should be doing is tell a country we should give up our claims. But there comes a time when you have to face reality. The problem historically has not been that countries have been to eager to renege on their financial obligations, but often too reluctant.