Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets
by Gabriel Cuadra of the Banco de México, and
Abstract: Emerging economies tend to experience larger political uncertainty and more default episodes than developed countries. This paper studies the effect of political uncertainty on sovereign default and interest rate spreads in emerging markets. The paper develops a quantitative model of sovereign debt and default under political uncertainty in a small open economy, where the ruling party is able to sell non contingent bonds to foreign lenders. The model captures some of the main empirical regularities in emerging economies: default occurs in equilibrium and interest rate spreads and default risk are countercyclical. 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 the spreads. When parties borrow from international credit markets, they know that there is a positive probability of being out of power next period. In that case they would not be asked to pay the country's foreign debt. In this way, the presence of political uncertainty induces a short-sight behavior in politicians.
Keywords: Default, Sovereign Debt, Political Risk.
Published in: Journal of International Economics, Vol. 76, No. 1, (September 2008), pp. 78-88.