| Abstract : | Over the last eight years Eurozone has been suffering a debt crisis. Several Eurozonemember states became incapable of meeting their government debt repayments and thusresorted to the aid of International Institutions to receive financial assistance. However,two Eurozone members stand out each one for its unique features vis-à-vis the other eurocountries, Greece and Portugal. The former due to the fact that it has been confronted withsalient sovereign risk, having the highest debt to GDP ratio in the Eurozone, and the latterdue to the fact that, unlike the other countries, did not boom during the pre-crisis period,despite enjoying large capital flows from abroad. We present a model of credit frictions toshow that the integration of the European financial markets doesn’t suffice for output torise without efficient financial deepening. The underdeveloped Portuguese financial marketcaused the capital inflows to be largely misallocated, generating the slump of 2000-07 asrelatively unproductive firms in the nontradable sector expanded at the expense of moreproductive tradable firms. We benchmark the behavior of Portugal against different kindsof financial shocks imposed to the model. We argue that the same model that predicts thePortuguese slump can account for the similarities and the differences between Portugal andthe other euro countries during this period and the steep recession after 2010 as well.
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