Sovereign Spreads and Contagion Risks in Asia

Abstract

In the aftermath of the recent global financial turmoil, sovereign spreads have exhibited a significant degree of volatility. This paper explores how much of these movements in the spreads of Asian economies reflected shifts in global risk aversion or country‐specific risks, directly from worsening fundamentals, or indirectly from spillovers originating in other sovereigns, or risks and uncertainty surrounding their exchange rates. This analysis finds that earlier in the crisis, the increase in market‐implied contagion led to an increase of sovereign bond yields relative to the swaps. Higher‐rated sovereign bonds in Asia benefited from the flight to quality that accompanied the increase in global risk aversion during this period. Once the systemic risks in the financial sectors worldwide were contained, the risk of sovereign spillovers eased, which, together with a fall in perceived currency‐related risks, led to a fall in sovereign bond yields relative to swaps yields across the board. Comparing the situation to that of Europe, the present paper concludes that the debt crisis in the euro area has not affected the perception of sovereign risks of Asian economies. In fact, a fall in exchange rate and spillover risks, combined with stronger fundamentals, have led to a continued normalization of Asian sovereign spreads since the height of the financial crisis.