Financial stress and the probability of sovereign default

Abstract

Economic vulnerabilities may remain latent for long periods and may only reveal their full impact on a country’s fiscal sustainability when the economy undergoes a significant shock. This could lead researchers to understate the impact of such vulnerabilities on a country’s probability of sovereign default, particularly at times of global or local financial stress. We analyze data from a panel of 113 countries over the period 1990–2014 to examine the impact of debt burden indicators and macro fundamentals on risk of sovereign default in emerging markets and advanced economies. We test whether economic fundamentals and fiscal vulnerabilities have a stronger impact on the risk of sovereign default during periods of financial distress than during tranquil times. We find that financial stress significantly amplifies the impact of the debt-to-GDP ratio, the stock of international reserves, and GDP per capita on the probability of sovereign default.