Interest Rate Uncertainty and Sovereign Default Risk

Abstract

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). Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.