Sovereign Debt Spreads in a Markov Switching Regime

by Burcu Eyigungor of the University of California, Los Angeles

November 13, 2006

Abstract: In a sovereign debt model with endogenous default, I add uncertainty about the long-run prospects of the emerging country to account for the high spreads and relatively frequent default episodes observed in these countries. The existing literature cannot account for the business cycle moments of the spreads: the spreads are generally too low and when they are increased through some adjustments to the model, volatilities of spreads exceed the data. In the model of this paper, agents (the country and international investors) do not have direct information about the long-run output trend, but can infer a long run trend through period output realizations. If the country is already stagnating and there is pessimism about the future then default is less costly for the country and it might choose to default. In addition, because of this uncertainty, the country is willing to pay high interest rates in the short run as it tries to determine whether a bad output realization is just temporary or whether the long-run prospects have indeed deteriorated. The model is able to account for business cycle moments of spreads, and also generate other emerging market business cycle facts such as countercyclical interest rates, a countercyclical current account, and more volatile consumption relative to output.

JEL Classification: E44, F32, F34.

Keywords: Sovereign Default, Interest Rates, Business Cycles.

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