Abstract
This paper sheds new light on the “trade costs” of sovereign default. It argues that the decline in trade in the wake of sovereign debt crises documented in earlier studies is the result of a reduction in exporters’ access to foreign credit. Using an annual panel of 28 industries in 100 countries between 1980 and 2007, it shows that default leads to a stronger contraction in the exports of sectors which are more dependent on external financing, consistent with this hypothesis. This finding is robust across different econometric specifications, and of economically significant magnitude. It suggests that any impact of sovereign default on trade, rather than a cost of default in its own right, may be a symptom of reduced access to international capital markets.
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Notes
Following Do and Levchenko (2007), I calculate country c's average financial dependence of exports in year t as ∑ i FinDep i Exp cit /∑ i Exp cit where Exp cit are sector-i exports by country c in year t, and FinDep i is a measure of the financial dependence of production in sector i. Data sources and definitions are discussed in greater detail in Section II.
See Gelos, Sahay, and Sandleris (2003), Arteta and Hale (2008), Fuentes and Saravia (2010), and Mendoza and Yue (2008) for recent examples.
By contrast, Mitchener and Weidenmier (2005) document that between 1870 and 1914, disgruntled creditors did resort to gunboat diplomacy to punish instances of sovereign default, and that such “supersanctions” triggered a decline in trade.
Following their seminal paper on financial development and growth, the Rajan-Zingales methodology has been adopted by a number of authors for empirical studies in a variety of contexts. Among others, it has been used to examine the effect of financial development on growth and output volatility (Braun, 2003; Fisman and Love, 2003; Raddatz, 2006), the impact of financial liberalization on exports and growth (Manova, 2008; Levchenko, Rancière, and Thoenig, 2009), and the consequence of banking crises for value added and exports (Kroszner, Laeven, and Klingebiel, 2007; Iacovone and Zavacka, 2009).
For example, Sandleris (2008) shows that debt repayment may be used optimally by governments to signal private information about their future stance toward foreign creditors. In his model, default signals a hostile future environment for foreign creditors, and thus reduces foreign investment. Similar informational assumptions can also be used to motivate a rise in π ct following sovereign default.
Note that the model generates a one-for-one relationship between an industry's capital intensity and its financial dependence by assumption, but this is not a necessary condition for the Rajan-Zingales methodology to be applicable. Their approach—a variant of which will be employed in Section II—only requires that (i) interest-rate shocks have a bigger effect on the production cost of more financially dependent sectors and (ii) financial dependence is a technological feature of each industry that is fixed in the short run. The model outlined in this section provides one example of a setting in which these conditions are met.
None of the paper's main results are sensitive to using only mirrored or only exporter-reported trade flows.
For a more detailed discussion, see Rajan and Zingales (1998).
See Beck (2003) and Nunn (2007) for two papers which test this hypothesis formally, and find it to be supported by the data.
Income groups are based on the World Bank's classification of countries into low income, lower-middle income, upper-middle income, non-OECD high income, and OECD high income.
The dates of banking and currency crises are based on Laeven and Valencia (2008) and reported in Table A2.
Note that Rose (2005) and Martinez and Sandleris (2008) use renegotiations of publicly held debt through the Paris Club to construct their default dummy, while I use records of defaults on private bank and bond debt. The Paris Club data are useful to the particular question these studies attempt to address, but Paris Club renegotiations are more frequent than the repudiation of privately held debt—giving rise to multicollinearity problems in lagged models—and arguably less representative of the noncooperative nature of default commonly alleged in the theoretical literature.
One way to think about Figure 2 is as a plot of the distribution of Equation (13) for the 61 debt crises assuming β2=0. To construct the figure, I use the average financial dependence of exports for each defaulter in the three years prior to the debt crisis, and let β̂1=(1/3)(β̂10+β̂11+β̂12)≈−0.324 from my baseline regression.
The use of instruments in the present context faces the insurmountable challenge of identifying a variable that is highly correlated with a country's propensity to default on foreign debt, but uncorrelated with the volume of its exports.
My PSM approach in this section closely follows Levchenko, Rancière, and Thoenig (2009). The interested reader is referred to their paper for a more detailed discussion of the PSM methodology.
As the “foreign debt risk” scores have only been calculated since 1985, I am forced to restrict my PSM analysis to default episodes which occurred after this date.
References
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Additional information
*Robert Zymek obtained his PhD from Universitat Pompeu Fabra in September 2011. He is an Assistant Professor at the School of Economics, University of Edinburgh. The author is grateful to Jaume Ventura for his advice and encouragement. He would also like to thank two anonymous referees, Alberto Martin, Hans-Joachim Voth, and participants of the Spring Meeting of Young Economists 2009, the EEA-ESEM Congress 2009, the CREI International Lunch and the CEP/LSE International Economics Seminar for helpful comments and suggestions.