In the present paper, we investigate the propagation and amplification mechanisms of an unanticipated adverse shock to the country risk premium on foreign-currency denominated funds in a dynamic stochastic general equilibrium model of a two-sector small open economy. The model incorporates a financial market friction in the form of an endogenous risk premium which depends on the economy’s level of external debt. This friction amplifies the initial financial shock, especially, when the economy is highly indebted and is subject to large currency mismatches.

Under a flexible exchange rate regime, the exchange rate depreciates immediately and the shock is enforced by two main channels: (1) the domestic value of outstanding debt rises (adverse balance sheet effect); and (2) the endogenous term of the risk premium increases with the higher debt burden. As a result, domestic consumption, investment, and capital inflows drop sharply. In this scenario of capital account dominance, the current account has to adjust to the capital account restrictions. The involved sudden stop is partly offset by a shift of resources from the non-tradable to the tradable goods sector and the associated export expansion counteracts the reduction in imports. The associated adjustment is most painful when liability dollarization is coupled with a small tradable goods sector.