Sovereign default, interest rates and political uncertainty in emerging markets

Abstract

Emerging economies tend to experience larger political uncertainty and more default episodes than developed countries. This paper studies the effect of political risk on sovereign default and interest rate spreads in emerging markets. The paper develops a quantitative model of sovereign debt and default under political risk in a small open economy that captures some of the main empirical regularities in emerging economies: default occurs in equilibrium and interest rate spreads and default risk are countercyclical.More polarized economies experience higher default rates and larger level and volatility of spreads. Also consistent with empirical evidence, the quantitative analysis shows that higher levels of political uncertainty significantly raise the default frequency and both the level and volatility of spreads.

Sharing a ride on the commodities roller coaster: Common factors in business cycles of emerging economies

“…The log-linearized version of the model presented in the Appendix illustrates this. 24 Another possible offsetting mechanism which may dampen the size of the income shock triggered by the increase in commodity prices is an increase in the price of consumption goods. If the latter increases more than nominal GDP the income effect will be offset and real income, GDP/p c , could actually fall.…”

“…(2003) found that improved terms of trade are associated with lower yield spreads to the extent that such improvements imply an increase in export earnings and better repayment capacity. Cuadra and Sapriza (2006) link the volatility of terms of trade in EMEs to spreads in a dynamic model with strategic default model that delivers endogenous default risk, but do not explore the implications for the business cycle. Using FAVAR models, Bastourre et al (2012) have also documented a strong negative correlation between commodity prices and emerging market spreads.…”

The Political Determinants of Government Bond Holdings

“…Here, the more polarized the veto players are, the stronger the effect. Cuadra and Sapriza (2008) have a different prediction for the effect of ideological polarization in the legislature: In their model of political uncertainty, the incumbent party has the incentive to overspend as it knows that it might not be in office in the next term. This incentive increases with the ideological distance to the competing parties, as these prefer a different distribution of wealth.…”

How Well Do We Understand Sovereign Debt Crisis? Evidence from Latin America

“…This can imply that some governments, which were almost sure to repay their debt before A's default, find market conditions for new debt issues worsened and thus might now prefer to default. Cuadra and Sapriza (2008) and Hatchondo et al (2009) present models where parties in power rather than an everlasting government issue and default on debt. In Cuadra and Sapriza's model, two parties alternate in power and each party cares for "its" share of the population more than for the rest of the population.…”