Capital Flight and Sovereign Default

Abstract:
We explore the deleverage effects through which a sovereign default can disrupt the domestic economy through its banking system. First, a default not only creates a negative balance-sheet effect on domestic banks, but also causes these banks to delever via foreign investment withdrawal. Such deleverage undermines the overall return of domestic private sectors by suppressing the endogenous growth opportunities. Due to the diminished investment returns, banks have to divert resources from domestic Hi-Tech industries to foreign markets. The capital flight occurs with sharp contraction in employment and aggregate output. A quantitative analysis of the model shows that this mechanism generates a deep and persistent fall in post-default output, which accounts for the government’s commitment necessary to explain observed levels of capital flows, private sector credits and Hi-Tech exports. The model is used to study policies that address the government’s lack of commitment.

Presented or Accepted for Presentation at:

• Advanced Computational Economics and Finance, May 2019, Zürich