Do Macro-Economic Fundamentals Price Emerging Market Sovereign CDS Spreads?

Abstract

This paper investigates the extent to which macro-economic variables govern the dynamics of emerging market sovereign CDS spreads. I propose a structural model of sovereign credit risk based on a country's access to international capital flows through exports, imports and international reserves. Using these macro-fundamentals, I define a sovereign's ability to pay as the maximum amount of foreign currency available for repayment of external debt. The joint dynamics of the ability to pay and the amount of outstanding debt determine the level of default risk and thus the sovereign CDS spread. I implement the model for a sample of six emerging economies for a period covering the recent financial crisis. A calibrated version of the model captures the widening of sovereign spreads during the crisis and provides a good fit for their time-series dynamics. Lastly, I use the model to measure the market-implied level of country liabilities. On average, the value of implied external debt is 13% larger than the reported level of debt.

Keywords: sovereign credit risk, sovereign CDS, emerging market CDS