Sovereign Risk, Net Foreign Assets and Exchange Rate Dynamics in Developing Economies

Abstract

We show that sovereign risk premium contains important information about the short run exchange rate dynamics in emerging economies and that net foreign assets play the key role in the link between the two variables: on the one hand, the accumulation of foreign assets reduces the sovereign risk premium, since it provides a crude form of collateral, appreciating the nominal exchange rate; on the other hand, the exchange rate appreciation worsens the trade balance, having a negative effect on the accumulation of net foreign assets. Our model is tested in two steps. First, we use annual data for the most liquid USD denominated external debt emerging markets and show how sovereign risk premium decreases with the level of net foreign assets. Second, we select from the original group the countries with a de facto independent floating exchange rate regime and show that out-of-sample forecasts using realized values for the sovereign risk premium successfully outperform a random walk.