Puerto Rico’s unique characteristics as a U.S. territory allow us to examine the transmission of quasi-sovereign default risk to the real economy. Authors document a negative relationship between increased default probabilities and employment growth in government-demand-dependent industries. The negative relationship strengthens when the government undertakes austerity measures. In addition, fiscal austerity reduces output growth via a local fiscal multiplier effect. Overall, they provide evidence for a novel demand-driven transmission mechanism of sovereign default risk that operates through austerity risk and government demand dependence.