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News and sovereign default risk in small open economies

  • Ricardo Nunes

    (Federal Reserve Board)

  • Horacio Sapriza

    (Federal Reserve Board)

  • Bora Durdu

    (Federal Reserve Board)

This paper builds a model of sovereign debt in which default risk, interest rates, and debt depend not only on current fundamentals but also on news about future fundamentals. News shocks affect equilibrium outcomes because they contain information about the future ability of the government to repay its debt. First, in the model with news shocks not all defaults occur in bad times, bringing the model closer to the data. Second, the news shocks help account for key differences between emerging markets and developed economies: a higher precision of news about future fundamentals lowers the uncertainty that agents face and partially completes financial markets. As the precision of news improves, the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt more in line with the characteristics of developed economies. Finally, the model also captures the hump-shaped relationship between default rates and the precision of news obtained from the data.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1355.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1355
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