The Transmission of Quasi-Sovereign Default Risk: Evidence from Puerto Rico

Puerto Rico’s unique characteristics as a US territory allow us to examine the transmission of quasi-sovereign default risk to the real economy. Increased default probabilities predict a significant decline in monthly employment growth in government-demand-dependent industries. The relationship between increased default risk and declining employment growth further strengthens when the government undertakes austerity measures. In addition, fiscal austerity reduces output growth via a local fiscal multiplier effect. Overall, the paper presents evidence for a novel demand-driven transmission mechanism where sovereign default risk operates through austerity risk and government demand dependence.