MACRO: Dr Minjie Deng (Simon Fraser University)

Trade Barriers and Sovereign Default Risk

We develop a quantitative general equilibrium model of sovereign default with trade and financial frictions to study how trade shocks shape sovereign risk and how sovereign risk, in turn, distorts trade. The model features imported intermediate inputs subject to import cost shocks and working-capital requirements, exports subject to export cost shocks, and a government that issues defaultable debt. The model generates an endogenous feedback loop: trade cost shocks elevate default risk and spreads, which further compress trade through the working capital channel. Quantitatively, the model delivers a pronounced asymmetry across trade shocks: export cost shocks account for most of the model-implied variation in default risk and sovereign spreads, whereas import cost shocks have comparatively small effects on spreads. Guided by the model, we construct empirical measures of import and export wedges in a cross-country panel and document strong comovement between trade wedges and sovereign spreads, with the tightest relationship for the export wedge. The model shows that the interaction of productivity, export, and import cost shocks explains the spread spike and the overall severity of the 2008-2009 Great Recession.