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Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt

There is tremendous variation in the interest rates emerging market governments pay on their external debt. This is true both across countries and over time. A common measure of a country’s borrowing cost in international capital markets is its yield spread, which is defined as the difference between the interest rate the government pays on its external U.S. dollar denominated debt and the rate offered by the U.S. Treasury on debt of comparable maturity.

In this paper we consider to what extent macroeconomic fundamentals can explain variation in sovereign yield spreads. We focus in particular on the explanatory power of the volatility of fundamentals. From a theoretical perspective, the volatility of fundamentals should matter for the pricing of defaultable debt, just as the level of these fundamentals does.

All else equal, a country with more volatile fundamentals is more likely to experience a severe weakening of fundamentals which may force it into default. This risk should be reflected in a higher yield spread on its bonds. While this idea is well understood in theory, it has been largely ignored by the empirical literature on sovereign debt, which has tended to focus on level variables. In contrast, we include both the level and the volatility of macroeconomic fundamentals in our empirical analysis.

There are two main parts to the paper. In the first part, we analyze the effect of country-specific fundamentals and global factors on sovereign debt prices for a set of 31 emerging market countries from 1994 to 2007. We measure yield spreads on external U.S. dollar denominated debt using data from J.P. Morgan’s Emerging Market Bond Index (EMBI). In the second part, we examine the effect of these macroeconomic variables on the probability of default, using data from 1970 to 2007. We also relate out-of-sample fitted default probabilities to observed spreads.

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Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt