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The aim of this paper is to assess the short and medium-term impact of debt crises on GDP. Using an unbalanced panel of 154 countries from 1970 to 2008, the paper shows that debt crises produce significant and long-lasting output losses, reducing output by about 10 percent after 8 years. The results also suggest that debt crises tend to be more detrimental than banking and currency crises. The significance of the results is robust to different specifications, identification and endogeneity checks, and datasets.

The recent general increase in public debt levels and severe funding pressures faced by some European countries have brought again attention to the problems of sovereign debt. Although it is a common view that debt crises may be detrimental and that large increases in public debt have frequently led to sovereign defaults, only few studies have tested the effect of debt crises on output, and even fewer papers have focused on the timing of the recovery after debt crisis episodes.2 The economic literature has identified three main channels through which sovereign debt crises affect output.3 The first channel is through the exclusion from international capital markets. Gelos et al. (2011) show that after a sovereign default, countries were excluded from international capital markets for about four years on average. Similarly, Richmond and Dias (2008) find that exclusion from international capital markets after a sovereign default lasted on average 4 years: 5.5 years for debt crisis episodes in the 1980s, 4.1 years in the 1990s, and 2.5 years in the 2000s. The second channel is through an increase in the cost of borrowing. For example, Borensztein and Panizza (2009) find that for 31 emerging market economies in the period 1997–2004, in the year after a sovereign default episode spreads increased by about 400 basis points compared to tranquil times. The third channel is through international trade. Rose (2005) finds a significant reduction in bilateral trade of approximately 8 percent per year following the occurrence of a sovereign default.4 In addition to these channels, debt crises can affect output indirectly by leading to banking and currency crises (De Paoli et al. 2009). The results of the empirical literature on the relation between sovereign default and growth have in general confirmed that debt crises may lead to significant output contractions. Sturzenegger (2004), using cross-country and panel regressions, finds that debt defaults are associated with a reduction in output growth of about 0.6–2.2 percentage points. Similarly, Borensztein and Panizza (2009) find that defaults are associated with a decrease in growth of 1.2 percentage points per year. De Paoli et al. (2009), comparing output growth five years before and after the occurrence of a debt crisis, find that debt crises are associated with large output losses of at least 5 percent per year. In contrast, Levy-Yeyati and Panizza (2011), analyzing quarterly data for output growth, find that growth recovers in the quarters immediately after the occurrence of a debt crisis.5 However, the results of these growth regressions should be interpreted with some caution since they may suffer from two main biases. First, sovereign debt crises may be endogenous to output contractions. Indeed, many episodes of debt defaults have occurred in period of strong output contractions. Chiang and Coronado (2005) and Borensztein and Panizza (2009) attempt to address this issue by using a two-step approach in which the probability of sovereign defaults is estimated in the first stage regression, and then used as a regressor in the second stage in the growth regression. However, this approach does not fully address endogeneity problems given the impossibility to find true strongly exogenous instruments for debt crises. In addition, the results of the second stage regression may be very sensitive to the particular model used to estimate debt crises probabilities. The second form of bias comes from the indistinguishable connection that exists between currency, banking and debt crises. This is particularly the case for emerging economies simultaneously hit by banking, currency, and debt crises. The simultaneous occurrence of these types of financial crises is often attributed to the so-called “original sin” syndrome ( Eichengreen et al., 2003), taking place when most of the private and public debt is short-term denominated in foreign currency. Following large domestic exchange rate depreciations associated with currency crises, public debt (when mostly foreign denominated) can increase considerably and lead to defaults. Reinhart and Rogoff, 2010a and Reinhart and Rogoff, 2010b suggest the following causality: private sector defaults precede banking sector crises that coincide or precede public debt defaults. At the same, the opposite may also occur: public debt defaults may lead to banking crises when banks are the main holders of government debt. Banking and debt crises could also lead to currency crises. For instance, third generation crises theory ( Krugman, 1999) underlines the role of maturity mismatches and currency disequilibria in private (mostly banking sector) balance sheets as the main reason for the onset of currency crises. This paper tries to address these issues. In particular, its contribution to the existing literature is fourfold: • It analyzes the impact of debt crises on output both in the short and in the medium-term. • It attempts to address endogeneity and reverse causality by using two approaches. The first, in line with the most recent empirical literature that analyzes the determinants of growth in a panel framework, consists of using a two-step GMM-system estimator. The second approach consists of estimating the impact of debt crises on growth using the two-step GMM only for those debt crises episodes that occurred in periods of relatively good economic performance. • It tries to isolate the impact of debt crises from the effect of banking and currency crises using two different estimation strategies. The first approach consists of estimating the effect of debt crises on output together with the effect of currency and banking crises. In this way, it is possible to quantify the marginal contribution of each crisis to output. In the second strategy, the effect of debt crises on output is estimated only for those episodes for which neither a banking nor a currency crisis occurred in the 2 years before, during, or after the onset of a debt crisis. • To check the robustness of our results, several datasets of starting dates for debt crises episodes are used. The estimates based on an unbalanced panel of 154 countries from 1970 to 2008 suggest that debt crises are very costly to output both in the short and in the medium-term. In the short-term, the results suggest that debt crises reduce contemporaneous output growth by about 6 percentage points. The results are robust to different specifications, and to different robustness checks to control for endogeneity and identification of debt crises (vs. banking and currency crises). In particular, focusing on those debt crisis episodes characterized by contemporaneous favorable economic performance, the analysis suggests that debt crises reduce output growth by about 6–10 percentage points. Similarly, focusing on debt crisis episodes for which neither a banking nor a currency crisis occurred in the two 2 years before, during, or after the onset of a debt crisis, the results confirm that debt crises significantly and negatively affect contemporaneous output growth, with a magnitude of the effect of about 8 percentage points. The results are also robust to alternative datasets with a magnitude of the effect ranging from 5 to 10 percentage points. Debt crises are also associated with significant output losses over the medium-term: 8 years after the occurrence of a debt crisis, output contracts by about 10 percent. The statistically significance of the result is robust to the estimation procedures used (local projections and ARDL) and to different specifications. Finally, the paper presents empirical evidence that output growth is reduced not only when a debt crisis occurs, but also when public (total and foreign) debt exceeds a given threshold. The rest of the paper is organized as follows. Section 2 describes the data and the identification of debt crises episodes. Section 3 presents the empirical methodology used to assess the short and medium-term effects of debt crises on output, and the results. Section 4 summarizes the main results and concludes with some issues for future research.

The paper analyzes the short and medium-run effects of debt crises on output for an unbalanced panel of 154 countries from 1970 to 2008. The results suggest that in the short-term debt crises are very detrimental, reducing contemporaneous output growth by 6 percentage points. The results are robust to different specifications, and to different robustness checks to control for endogeneity and identification of debt crises (vs. banking and currency crises). In particular, focusing on those debt crisis episodes characterized by contemporaneous relatively good economic performance, the analysis suggest that debt crises reduce output growth by about 6–10 percentage points. Similarly, focusing on debt crises episodes for which neither a banking nor a currency crisis occurred in the two 2 years before, during, or after the onset of a debt crisis, the results confirm that debt crises significantly and negatively affect contemporaneous output growth, with a magnitude of the effect of about 8 percentage points. The results are also robust to alternative datasets with a magnitude of the effect ranging from 5 to 10 percentage points. Since these datasets mainly differ in the composition of the countries for which a debt crisis is attributed, rather than the dating of the crisis itself, it is likely that the different estimates simply reflect the heterogeneous response of countries to the debt crises and the different severity of the crises. These differences are, however, not statistically significant. The medium-term analysis confirms the negative effect of debt crises on output growth. In particular, debt crises are associated with persistent output losses: 8 years after the occurrence of a debt crisis, output contracts by about 10 percent. The statistically significance of the result is robust to the estimation procedures used (local projections and ARDL) and to different specifications. These are large estimates and should alarm policy makers about the risks of defaults. Our study suggests that a number of interesting extensions can be pursued. First, as suggested by the results obtained by using different datasets, the response of output to debt crises may vary across countries. Therefore, it would be useful to empirically examine the determinants of this heterogeneity. An additional promising direction would be to expand the investigation on whether output is negatively affected not only by the occurrence of a debt crisis, but also when public (total and foreign) debt exceeds a particular threshold. The results presented in the paper suggest that output growth declines by about 1.8 percentage points (2.4 percentage points) when the gross debt-to-GDP ratio (foreign debt-GDP ratio) exceeds 70 (80) percent. This analysis could be extended by analyzing thresholds with non-parametric (or semi-parametric) approaches, and by looking at possible interactions between the share of public (total and foreign) debt and other variables such as trade openness, domestic saving, financial integration, financial development, and measures of perceived country risks.