Few would dispute that sovereign defaults entail significant economic costs, including, most notably, important output losses. However, most of the evidence supporting this conventional wisdom, based on annual observations, suffers from serious measurement and identification problems. To address these drawbacks, we examine the impact of default on growth by looking at quarterly data for emerging economies. We find that, contrary to what is typically assumed, output contractions precede defaults. Moreover, we find that the trough of the contraction coincides with the quarter of default, and that output starts to grow thereafter, indicating that default episode seems to mark the beginning of the economic recovery rather than a further decline. This suggests that, whatever negative effects a default may have on output, those effects result from anticipation of a default rather than the default itself.
Eduardo Levy-Yeyati is Professor of Economics and Finance at the Barcelona Graduate School of Economics and the Business School of Universidad Torcuato Di Tella, Buenos Aires (where he also directed the Center for Financial Research from 1999 to 2007). Ugo Panizza is the Chief of the Debt and Finance Analysis Unit in the Division on Globalization and Development Strategies of UNCTAD. He is also a visiting professor at the Graduate Institute, Geneva, where he teaches econometrics and development economics. This paper is the Inter-American Development Bank Research Department Working Paper #581 (November 2006).