Risky Sovereign Capital Structure: Macrofinancial Diagnostics

Abstract

We develop an enhanced structural credit risk Leland-style model for a sovereign issuer with both domestic and foreign debt. While previous research has primarily focused on the fundamental valuation of local and foreign currency bonds, we extend this by addressing their consistent pricing in an out-of-equilibrium market environment—a situation that is more the norm than the exception, as countries rarely operate at their full macroeconomic potential. We propose a consistent working setting which also provides a powerful tool to analyze in a uniform way from a no-arbitrage macrofinancial point of view policies and flows affecting the capital structure of the sovereign. We place special emphasis on issues related to FDI, FX interventions and sterilizations, debt issuance and buybacks, quantitative easing and tapering, as well as monetary policy open market operations, and their influence on bond prices and risky sovereign spreads. They matter in relative value analysis and, when combined with considerations whether the economy functions at the potential under an optimal capital structure, provide relevant strategic and tactical investment insights as well as policy prescriptions for effective macroeconomic management. We conclude with an empirical application to a broad set of currency union, developed, and emerging market countries.

Keywords: structural credit risk model, sovereign capital structure, macrofinancial flows, bonds, monetary policy

JEL Classification: F30, E43, G12, G15, C58