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Interest Rate Uncertainty and Sovereign Default Risk

Author

Listed:
  • Shahed Khan

    (McMaster University)

  • Cesar Sosa-Padilla

    (McMaster University)

  • Alok Johri

    (McMaster University)

Abstract

As the United States emerged from the Great Recession, there was considerable uncer- tainty around the future direction of US monetary policy exemplified by the chatter and speculation around tapering of quantitative easing by the US Fed in the financial press. The increased uncertainty around the timing and speed of the tapering coincided with a sharp spike in the sovereign bond yields of several emerging economies. We explore the impact of an increase in interest rate uncertainty on the borrowing costs of a small open economy in an otherwise standard model of sovereign default, where spread is endogenous. We find that introducing time-varying volatility in the world interest rate (i.e. uncertainty shocks) the model predicts a mean sovereign spread that is 115% larger and 126% more volatile. The model also predicts that countries default more than twice as frequently. Moreover, the equilibrium debt-to-income ratio is 19% lower. The welfare gains from eliminating uncertainty about the world interest rate amount up to a 1.8% permanent increase in consumption. Overall, we find quantitative support for the widespread con- cerns regarding the uncertainty about when and how the Fed will unwind its quantitative easing.

Suggested Citation

  • Shahed Khan & Cesar Sosa-Padilla & Alok Johri, 2016. "Interest Rate Uncertainty and Sovereign Default Risk," 2016 Meeting Papers 1676, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:1676
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    2. Javier Bianchi & Cesar Sosa-Padilla, 2018. "Reserve Accumulation, Macroeconomic Stabilization and Sovereign Risk," 2018 Meeting Papers 1166, Society for Economic Dynamics.
    3. Sosa-Padilla, César & Sturzenegger, Federico, 2023. "Does it matter how central banks accumulate reserves? Evidence from sovereign spreads," Journal of International Economics, Elsevier, vol. 140(C).
    4. Grace Weishi Gu & Zachary R. Stangebye, 2023. "Costly Information And Sovereign Risk," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 64(4), pages 1397-1429, November.
    5. Dooyeon Cho & Dong‐Eun Rhee, 2024. "Determinants of market‐assessed sovereign default risk: Macroeconomic fundamentals or global shocks?," International Finance, Wiley Blackwell, vol. 27(1), pages 35-60, April.
    6. Mohsin Waheed & Zulfiqar Hyder, 2023. "What Explains the Volatility in Pakistan’s Sovereign Bond Yields?," SBP Working Paper Series 112, State Bank of Pakistan, Research Department.
    7. Liu, Ailan & Wang, Zhixuan & Wang, Ping, 2024. "Official or unofficial? extreme bounds analysis on the determinants of sovereign default," The North American Journal of Economics and Finance, Elsevier, vol. 72(C).
    8. Reyes-Heroles, Ricardo & Tenorio, Gabriel, 2019. "Regime-switching in emerging market business cycles: Interest rate volatility and sudden stops," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 81-100.
    9. de Ferra, Sergio & Mallucci, Enrico, 2022. "Sovereign risk matters: Endogenous default risk and the time-varying volatility of interest rate spreads," Journal of International Economics, Elsevier, vol. 134(C).
    10. Gonzalez-Aguado, Eugenia, 2022. "Interest Rate Shocks and the Composition of Sovereign Debt," TSE Working Papers 22-1379, Toulouse School of Economics (TSE).

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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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