Working Paper: NBER ID: w27639
Authors: Alok Johri; Shahed Khan; Cesar Sosapadilla
Abstract: Empirical studies suggest that fluctuations in the level and volatility of the world interest rate affect sovereign spreads in emerging economies. We incorporate an estimated time-varying process for the world interest rate (with both level and volatility shocks) into a model of sovereign default calibrated to a panel of emerging economies. Time variation in the world interest rate interacts with default incentives in the model and leads to state contingent effects similar to the empirical literature. On average, in response to a rise in the world interest rate the model delivers a 1.4 times increase in the spread. The volatility state has a major impact on this average – the increase in spreads is much larger in high volatility states. Moreover, we show that fluctuations in the world interest rate can generate considerable co-movement in sovereign yields across nations, as seen in the data.
Keywords: Sovereign Default; Interest Rate; Emerging Economies; Volatility; Sovereign Spreads
JEL Codes: E32; E43; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| World interest rate increase (E43) | Sovereign spreads increase (H63) |
| High volatility (4 standard deviations above the mean) (C46) | Sovereign spreads increase (H63) |
| Low volatility (4 standard deviations below the mean) (C46) | Sovereign spreads increase (H63) |
| Higher debt levels (H63) | Sovereign spreads response to world interest rate increase (E43) |
| Fluctuations in world interest rate (E43) | Comovement in sovereign yields (G15) |