Who Saw Sovereign Debt Crises Coming?

Abstract

This paper studies sovereign debt crises during the period 1993-2006 through the prism of the primary sovereign bond market. Two conclusions emerge. First, investment banks price sovereign default risk well before crises occur and before investors detect default risk. Between three and one years prior to the onset of a crisis, sovereign default risk countries paid to investment banks on average 1.10 per cent of the amount issued, close to double the average paid by emerging countries overall in the same period (0.56 per cent). In contrast, the level of sovereign bond spreads prior to crises is on average only slightly higher than for emerging countries (385 vs. 319 basis points), suggesting that investment banks have an information advantage with respect to investors and are the only parties compensated for the risk of sovereign debt crises. Second, investment banks’ behaviour differs depending on the type of sovereign debt crisis. Before crises, investment banks charged on average a higher underwriting fee to countries presenting public finances difficulties than to other sovereign debt crisis countries. The robustness of these results is verified through panel data analysis. The results are puzzling in that they indicate that valuable, publicly available information is not tracked by investors to help improve allocation of their emerging market fixed income assets.