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Interest Rate Uncertainty and Sovereign Default Risk

Author

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  • Alok Johri
  • Shahed Khan
  • Cesar Sosa-Padilla
Abstract
International data suggests that fluctuations in the level and volatility of the world interest rate (as measured by the US treasury bill rate) are positively correlated with both the level and volatility of sovereign spreads in emerging economies. We incorporate an estimated time-varying process for the world interest rate 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 on borrowing and sovereign spreads which resemble those found in the data. The model delivers up to one-half of the positive comovement between the level and volatility of world interest rate and the level of sovereign spreads seen in emerging economies. Moreover, the model also delivers significant positive co-movements between the volatility of the spread and the process for the world interest rate which is also consistent with the data. Our model provides one potential source for the observed bunching in default probabilities observed across nations, namely the world interest rate process. Our model generates a positive and significant correlation (0.51) between the spreads of two nations with uncorrelated income processes. This is close to the observed mean correlation in the data (0.61).

Suggested Citation

  • Alok Johri & Shahed Khan & Cesar Sosa-Padilla, 2020. "Interest Rate Uncertainty and Sovereign Default Risk," Department of Economics Working Papers 2020-13, McMaster University.
    • Handle: RePEc:mcm:deptwp:2020-13
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    1. Alamgir, Farzana & Cotoc, Johnny & Johri, Alok, 2023. "The bribe rate and long run differences in sovereign borrowing costs," Journal of Economic Dynamics and Control, Elsevier, vol. 151(C).
    2. Yasmeen Bayaa & Mahmoud Qadan, 2024. "Interest rate uncertainty and the shape of the yield curve of U.S. treasury bonds," Eurasian Economic Review, Springer;Eurasia Business and Economics Society, vol. 14(4), pages 981-1003, December.
    3. Javier Bianchi & César Sosa-Padilla, 2024. "Reserve Accumulation, Macroeconomic Stabilization, and Sovereign Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 91(4), pages 2053-2103.
    4. Sosa-Padilla, César & Sturzenegger, Federico, 2023. "Does it matter how central banks accumulate reserves? Evidence from sovereign spreads," Journal of International Economics, Elsevier, vol. 140(C).
    5. Grace Weishi Gu & Zachary R. Stangebye, 2023. "Costly Information And Sovereign Risk," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 64(4), pages 1397-1429, November.
    6. Dooyeon Cho & Dong‐Eun Rhee, 2024. "Determinants of market‐assessed sovereign default risk: Macroeconomic fundamentals or global shocks?," International Finance, Wiley Blackwell, vol. 27(1), pages 35-60, April.
    7. Mohsin Waheed & Zulfiqar Hyder, 2023. "What Explains the Volatility in Pakistan’s Sovereign Bond Yields?," SBP Working Paper Series 112, State Bank of Pakistan, Research Department.
    8. Liu, Ailan & Wang, Zhixuan & Wang, Ping, 2024. "Official or unofficial? extreme bounds analysis on the determinants of sovereign default," The North American Journal of Economics and Finance, Elsevier, vol. 72(C).
    9. Marina Azzimonti-Renzo & Nirvana Mitra, 2024. "The Politics of Debt in the Era of Rising Rates," Working Paper 24-12, Federal Reserve Bank of Richmond.
    10. Reyes-Heroles, Ricardo & Tenorio, Gabriel, 2019. "Regime-switching in emerging market business cycles: Interest rate volatility and sudden stops," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 81-100.
    11. de Ferra, Sergio & Mallucci, Enrico, 2022. "Sovereign risk matters: Endogenous default risk and the time-varying volatility of interest rate spreads," Journal of International Economics, Elsevier, vol. 134(C).
    12. Gonzalez-Aguado, Eugenia, 2022. "Interest Rate Shocks and the Composition of Sovereign Debt," TSE Working Papers 22-1379, Toulouse School of Economics (TSE).

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    More about this item

    Keywords

    Sovereign Debt; Sovereign Default; Interest Rate Spread; Time-varying Volatility; Uncertainty Shocks;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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