Interest rate uncertainty and sovereign default risk

Abstract

Empirical studies suggest that fluctuations in the level and volatility of the world interest rate affect sovereign spreads in emerging economies. We incorporate an estimated time-varying process for the world interest rate (with both level and volatility shocks) 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 similar to the empirical literature. On average, in response to a rise in the world interest rate the model delivers a 1.4 times increase in the spread. The volatility state has a major impact on this average – the increase in spreads is much larger in high volatility states. Moreover, we show that fluctuations in the world interest rate can generate considerable co-movement in sovereign yields across nations, as seen in the data.