Interest Rate Uncertainty and Sovereign Default Risk
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).
We have benefited from comments and suggestions from the Fernando Broner, two anonymous referees, as well as from Manuel Amador, Agustín Benetrix, Marinho Bertanha, Nathan Converse, Ethan Ilzetzki, Hashmat Khan, Juan Carlos Hatchondo, Leonardo Martinez, Enrique Mendoza, Juanpa Nicolini, Ananth Ramanarayanan, Zach Stangebye, Michal Szkup, Martín Uribe, Stephen Williamson, and seminar participants at UBC, Saint's Mary, Western, Queen's, Carleton, Notre Dame, Trinity College Dublin, European University Institute, McMaster, Universidad Nacional de Tucum'an, the 2019 Midwest Macroeconomics Meeting, the 2019 Computing in Economics and Finance Annual Meeting, the 50th Anniversary of the Money, Macro and Finance Conference, the 10th RCEA MMF Conference, the 2016 and 2017 Society for Economic Dynamics Annual Meetings, and the 2015 Canadian Economic Association Annual Meeting. All remaining errors are ours. This research was partially funded by a Social Science and Humanities Research Council of Canada grant as well as internal Arts Research Board funding from McMaster University. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.