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Pricing of Sovereign Risk in Emerging Markets

Author(s):
International Monetary Fund. Research Dept.
Published Date:
March 2006
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Bernardin Akitoby

It is well established that financial markets’ assessment of sovereign risk is reflected in sovereign spreads. This raises a number of critical questions: What are the fundamental forces driving sovereign risk and spreads? Why are certain countries perceived as riskier than others? What is the relative importance of macroeconomic fundamentals and market sentiment in the pricing of sovereign risk? Does financial globalization heighten the role of common factors relative to country-specific factors in sovereign risk pricing? Does the IMF’s financial assistance induce moral hazard in the pricing of sovereign risk of countries undergoing financial crises? This article mainly reviews recent IMF research on these critical issues.

The empirical literature on the macroeconomic determinants of spreads has often sought to identify specific country characteristics affecting spreads. This line of analysis can arguably be traced to Edwards (1984), who shows that liquidity variables (e.g., the ratio of reserves to GDP) and solvency indicators (e.g., the ratio of debt to GDP) are the key determinants of sovereign spreads. Specifically, foreign currency reserves have a statistically negative effect, while debt has a statistically significant positive effect, on spreads. Catão and Sutton (2002) stress that macroeconomic volatility, as opposed to the levels of macroeconomic variables, plays a more predominant role in the probability of sovereign default. Using the history of credit events since the 1820s for more than a hundred countries, Reinhart, Rogoff, and Savastano (2003) show that default histories are associated with higher spreads. Moreover, they argue that countries with past serial defaults are likely to be afflicted by “debt intolerance”—that is, perceived as riskier at low or moderate debt levels. An alternative explanation for the debt-intolerance paradox is proposed by Catão and Kapur (2004), who argue that macroeconomic volatility not only raises spreads but also lowers a country’s debt-tolerance threshold.

Another important factor behind the pricing of sovereign risk relates to credit ratings. In a pioneering study, Cantor and Parker (1996) investigate how credit ratings affect sovereign spreads and conclude that they do so independently. Similarly, Sy (2001) uncovers a negative correlation between sovereign spreads and ratings that has increased over time. Interestingly, his findings suggest that in turbulent times, financial markets rely on factors other than ratings to differentiate between countries. Reinhart (2002) also suggests that sovereign credit ratings are a good predictor of default risk and, hence, changes in sovereign spreads. A more recent study, Andritzky, Bannister, and Tamirisa (2005), confirms that sovereign spreads respond to announcements of changes in international ratings, which are viewed as a composite indicator of country risk. It also points out, however, that in crisis times, the impact of rating changes on spreads tends to be less significant, because market participants view ratings as a backward-looking indicator in the context of rising uncertainty and volatility.

How do financial markets react to fiscal policy decisions of sovereign borrowers? Relatively few studies have focused on the effects of fiscal policies on sovereign bond spreads. A recent study, Akitoby and Stratmann (2006), investigates how the composition of fiscal adjustment is priced in sovereign bonds. Using a panel of 32 emerging market countries during 1994–2003, it finds that current expenditure-based adjustments significantly lower spreads, while fiscal adjustments that rely mostly on tax increases and drastic cuts in public investment have no statistically significant impact on the pricing of sovereign issues. This suggests that what matters for the financial markets is not a reduction in fiscal deficits per se but rather how the adjustment is brought about. Their findings also show that debt-financed current spending increases sovereign risk by more than tax-financed current spending, suggesting that international investors prefer the latter.

Some authors also highlight the role of monetary and exchange rate regimes in determining spreads. Jahjah and Yue (2004) investigate empirically the influence of exchange rate policy on sovereign bond spreads. They show that an overvalued real exchange rate significantly increases sovereign spreads, with the size of this effect being greater under a fixed exchange rate regime. During crisis periods, however, this result is reversed, with a free-floating regime leading to higher borrowing costs.

Other studies investigate whether the IMF’s financial assistance induces moral hazard in the pricing of sovereign risk of countries undergoing financial crises. Lane and Phillips (2000) investigate the reactions of bond spreads to three categories of events: (i) announcement of new IMF-supported programs in countries undergoing financial crises, (ii) news about the IMF’s financial resources or commitments to individual members, and (iii) news regarding Russia’s IMF program in 1998. In most cases, the authors fail to uncover any significant change in spreads in response to these events. Dell’Ariccia, Schnabel, and Zettelmeyer (2002), however, argue that these negative results are due to the deficiencies in the methodologies used. In studying the 1998 Russian crisis, they find that the IMF’s decision not to bail Russia out has made spreads more sensitive to country fundamentals and led to increases in the level and variance of spreads. These findings are interpreted as supporting the presence of IMF-related moral hazard.

A number of authors focus on the determinants of debt crisis, in view of the strong correlation between default episodes and higher spreads. Kaminsky, Lizondo, and Reinhart (1997) argue that variables providing early-warning signals of banking and currency crises may play a key role in explaining changes in spreads. They suggest that variables providing early-warning signals may include deviations of the real exchange rate from trend, equity prices, and the ratio of broad money to gross international reserves. Using a sample of 59 countries, Reinhart (2002) finds that debt crises tend to be preceded by currency crises. In their analysis of the role of liquidity indicators on default, Detragiache and Spilimbergo (2001) show that for a given total external debt, the probability of crisis increases with the proportion of short-term debt and debt service coming due; moreover, they show that the share of short-term debt is endogenous. In the same vein, Manasse, Roubini, and Schimmelpfennig (2003) develop an early-warning model of sovereign debt crises, which identifies solvency and liquidity factors that predict a debt-crisis episode one year in advance. The key factors include high levels of foreign debt relative to GDP, short-term debt relative to foreign reserves, and debt-service indicators.

The literature also points to the role of external factors—notably world interest rate shocks—in sovereign pricing. The empirical evidence on the impact of international interest rates on sovereign spreads is mixed. For example, Arora and Cerisola (2001) suggest that the stance and predictability of U.S. monetary policy are as important as country-specific fundamentals in determining country risk. They also show that the level of U.S. interest rates has had direct positive effects on sovereign bond spreads in several developing countries in Latin America, Asia, and Eastern Europe. In contrast, Eichengreen and Mody (1998a and 1998b) argue that U.S. interest rates in the 1990s were negatively associated with spreads for Latin American and East Asian countries. The authors explain this surprising finding as a result of the negative effect of a rise in U.S. rates on bond supply by emerging country issuers, which increased bond prices and, consequently, lowered sovereign spreads.

Increased financial globalization has also heightened the role of market sentiment and contagion in sovereign pricing. Many have argued that “irrational investor behavior” or a “herd mentality” often drive changes in sovereign spreads, largely because of the high costs of acquiring and processing information. In particular, using data on nearly 1,000 developing country bonds issued during 1991–96, Eichengreen and Mody (1998b) find that changes in spreads are mostly explained by market sentiment rather than macroeconomic fundamentals. Mauro, Sussman, and Yafeh (2002) also find that global events were the main driving forces behind changes in spreads in the 1990s, while country-specific events mostly explained change in spreads during the period 1870–1913.

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