U.S. Real Interest Rates and Default Risk in Emerging Economies

Abstract

We empirically analyse the appropriateness of indexing emerging market sovereign debt to US real interest rates. We find that policy-induced exogenous increases in US rates raise default risk in emerging market economies, as hypothesised in the theoretical literature. However, we also find evidence that omitted variables which simultaneously increase US real interest rates and reduce the risk of default dominate the hypothesised relationship. We can only conclude that it’s not a good idea to index emerging market bonds to US real interest rates.