Convergence and Divergence of Sovereign Bond Spreads

Abstract

Latin American sovereign bonds represent a significant share of the emerging debt class (50 per cent by early 2001) and so have considerably shaped the dynamics of this market.Recent financial turmoil, contagion episodes and investors' renewed concerns with debt default call for a better understanding of sovereign bond pricing (spreads) and its determinants, either macro fundamentals, contagion or other external variables.This paper addresses two important questions not fully tackled in the existing literature: i) to what extent do permanent or transitory changes in fundamentals affect sovereign risk perception, i.e. default risk, once contagion is controlled for?ii) how can a relatively high and volatile spread be the cause of unsustainable public debt accumulation?In order to answer these questions, we estimate long-term structural equations to pin down country risk determinants for Argentina, Chile and Mexico, using a time series framework spanning 1994-2000.Unlike former empirical work, we split fundamental variables into permanent and transitory components.Second, we explore through a vector error correction model (VECM) the short-term and long-term dynamics of the debt sustainability equation in Argentina and Mexico in order to assess how large the destabilising role of comparatively high spreads has been.Our main findings boil down to i) permanent changes in fundamental variables weigh most while contagion effects remain significant; ii) non-sustainable public sector deficits (increasing interest burden) plus insufficient economic growth and excessive risk premia are shown to have triggered explosive debt dynamics.

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