Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets - Working Paper 2006-01 - Abstract

Sep 4, 2026

Emerging economies exhibit larger terms-of-trade fluctuations, countercyclical interest rates, and more sovereign default episodes than developed countries. The study analyzes how terms-of-trade shocks drive output volatility and countercyclical sovereign spreads in a stochastic dynamic general equilibrium model for a small open economy. The model implies higher default incentives and higher default premia during recessions, consistent with observed data. Quantitative results show the model reproduces key features of emerging markets and explains the dynamics of default episodes.

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Banco de M􀀓exico Documentos de Investigaci􀀓on Banco de M􀀓exico Working Papers N􀀎 2006-01 Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets Gabriel Cuadra Banco de M􀀓exico Horacio Sapriza Rutgers University February 2006 La serie de Documentos de Investigaci􀀓on del Banco de M􀀓exico divulga resultados preliminares de trabajos de investigaci􀀓on econ􀀓omica realizados en el Banco de M􀀓exico con la 􀀌nalidad de propiciar el intercambio y debate de ideas. El contenido de los Documentos de Investigaci􀀓on, as􀀓􀀐 como las conclusiones que de ellos se derivan, son responsabilidad exclusiva de los autores y no re􀀍ejannecesariamente las del Banco de M􀀓exico. The Working Papers series of Banco de M􀀓exico disseminates preliminary results of economic research conducted at Banco de M􀀓exico in order to promote the exchange and debate of ideas. The views and conclusions presented in the Working Papers are exclusively the responsibility of the authors and do not necessarily re􀀍ect those of Banco de M􀀓exico. Documento de Investigaci􀀓on Working Paper 2006-01 2006-01 Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets* Gabriel Cuadray Banco de M􀀓exico Horacio Saprizaz Rutgers University Abstract Emerging economies tend to experience larger 􀀍uctuations in their terms of trade, countercyclical interest rates and more default episodes than developed countries. These structural features might suggest a relevant role for world prices in driving country spreads. This paper studies the role of terms of trade shocks in inducing output 􀀍uctuations and countercyclical spreads using a stochastic dynamic general equilibrium model of a small open economy. The model predicts that default incentives and default premia are higher in recessions, as observed in the data. In a quantitative exercise, the model matches various features of emerging economies and can account for the dynamics of default episodes in these markets. Keywords: Default, Terms of Trade, Sovereign Debt. JEL Classi􀀌cation: F34,F41 Resumen Las econom􀀓􀀐as emergentes tienden a experimentar mayores 􀀍uctuaciones en sus t􀀓erminos de intercambio y m􀀓as episodios de default soberano que los pa􀀓􀀐ses desarrollados. Estascaracter􀀓􀀐sticas estructurales sugieren un papel relevante para los choques externos en la generaci􀀓on de 􀀍uctuaciones econ􀀓omicas y spreads. Este art􀀓􀀐culo estudia el papel de choquesen los t􀀓erminos de intercambio sobre los incentivos a hacer default y las primas de riesgo, usando un modelo de equilibrio general para una econom􀀓􀀐a peque~na y abierta. El modelo predice que los incentivos a no pagar la deuda son mayores en recesiones, como se observa en los datos. En el an􀀓alisis cuantitativo, el modelo replica varias caracter􀀓􀀐sticas de las econom􀀓􀀐as emergentes. Palabras Clave: Default, T􀀓erminos de Intercambio, Deuda Soberana. * We are very much endebted to Per Krusell for encouragement and advice. We specially thank Alan Stockman for his suggestions. For useful comments we thank Roberto Chang, Rafael Del Villar, Alejandro Gayt􀀓an, Juan Hatchondo, Zvi Hercowitz, Josef Perktold, Vivian Yue, Lu Zhang and seminar participants at the University of Rochester, Rutgers Business School, Rutgers Economics Department, Banco de M􀀓exico, Bank of Canada, ITAM Business School, University of Oslo, the 2005 Midwest Macroeconomics Meeting and the 2006 North American Winter Meeting of the Econometric Society. y Direcci􀀓on General de Investigaci􀀓on Econ􀀓omica. Email: [gcuadra@banxico.org.mx](gcuadra@banxico.org.mx). z Rutgers Business School. Email: [hsapriza@andromeda.rutgers.edu](hsapriza@andromeda.rutgers.edu). 1. Introduction Small open emerging market economies diﬀer from developed economies in diﬀerent aspects: developing countries typically face large swings in the price of the goods they export. These countries rely heavily on a narrow range of primary commodities for their export earnings, and

FAQs

What is the main research question of the paper?

The paper examines how the level and volatility of terms of trade affect incentives to default and, consequently, equilibrium interest rates in developing countries.

What model framework does the paper use?

It uses a stochastic dynamic general equilibrium model of a small open economy with endogenous sovereign default risk.

How do terms-of-trade shocks influence defaults and spreads?

Terms-of-trade shocks induce output fluctuations that raise countercyclical default incentives and default premia, leading to higher sovereign spreads in recessions.

Sep 4, 2026

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