Abstract
This paper offers new theoretical and empirical insights into the effect of sovereign defaults on trade. We contend that sovereign debt renegotiation is associated not with trade sanction but with trade benefit between debtor countries and creditor countries. We find empirical support for the argument from the changes in trade share after debt renegotiations as well as the Aid-for-trade statistics. We build a two-country DSGE model with incomplete financial markets to explain why trade sanction is not observed. We reason that creditors lower trade costs with debtors in hopes of collecting the remaining debt during debt renegotiations. The adjustment in turn affects debtors’ default decisions. The model departs from the existing literature on sovereign defaults by building on the strategic interaction between debtors and creditors. We solve the model numerically to determine the optimal trade costs given different combinations of debt and income levels. We are also able to match the stylized facts of sovereign defaults including the high default occurrence and the correlation between debtors’ trade balance and income.
